- -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 1-13953 W. R. GRACE & CO. Delaware 65-0773649 - ---------------------------------- --------------------------- (State of Incorporation) (I.R.S. Employer Identification No.) 7500 Grace Drive Columbia, Maryland 21044 (410) 531-4000 ----------------------------------------- (Address and phone number of principal executive offices) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ----------- ---------- Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes X No ----------- ---------- 66,905,496 shares of Common Stock, $0.01 par value, were outstanding at April 30, 2005. - -------------------------------------------------------------------------------- W. R. GRACE & CO. AND SUBSIDIARIES Table of Contents ----------------- Page No. -------- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Report of Independent Registered Public Accounting Firm I - 1 Consolidated Statements of Operations I - 2 Consolidated Statements of Cash Flows I - 3 Consolidated Balance Sheets I - 4 Consolidated Statement of Shareholders' Equity (Deficit) I - 5 Consolidated Statements of Comprehensive Income (Loss) I - 5 Notes to Consolidated Financial Statements I - 6 to I - 23 Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition I - 24 to I - 36 Item 3. Quantitative and Qualitative Disclosures About Market Risk I - 37 Item 4. Controls and Procedures I - 37 PART II. OTHER INFORMATION Item 1. Legal Proceedings II - 1 Item 6. Exhibits II - 1 REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM TO THE SHAREHOLDERS AND BOARD OF DIRECTORS OF W. R. GRACE & CO.: We have reviewed the accompanying consolidated balance sheets of W. R. Grace & Co. and its subsidiaries as of March 31, 2005, and the related consolidated statements of operations, of shareholders' equity (deficit) and of comprehensive income (loss) for each of the three-month periods ended March 31, 2005 and March 31, 2004 and the consolidated statement of cash flows for the three-month periods ended March 31, 2005 and March 31, 2004. These interim financial statements are the responsibility of the Company's management. We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial statements to be in conformity with accounting principles generally accepted in the United States of America. The accompanying consolidated interim financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated interim financial statements, on April 2, 2001, the Company and substantially all of its domestic subsidiaries voluntarily filed for protection under Chapter 11 of the United States Bankruptcy Code, which raises substantial doubt about the Company's ability to continue as a going concern in its present form. Management's intentions with respect to this matter are also described in Note 1. The accompanying consolidated interim financial statements do not include any adjustments that might result from the outcome of this uncertainty. We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet as of December 31, 2004, and the related consolidated statements of operations, of cash flows, of shareholders' equity (deficit) and of comprehensive income (loss) for the year then ended, management's assessment of the effectiveness of the Company's internal control over financial reporting as of December 31, 2004 and the effectiveness of the Company's internal control over financial reporting as of December 31, 2004; and in our report dated March 4, 2005, we expressed (i) an unqualified opinion on those consolidated financial statements with an explanatory paragraph relating to the Company's ability to continue as a going concern and, (ii) unqualified opinions on management's assessment of the effectiveness of the Company's internal control over financial reporting and on the effectiveness of the Company's internal control over financial reporting. The consolidated financial statements and management's assessment of the effectiveness of internal control over financial reporting referred to above are not presented herein. In our opinion, the information set forth in the accompanying consolidated balance sheet information as of December 31, 2004, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived. /s/ PricewaterhouseCoopers LLP McLean, Virginia May 6, 2005 I-1 ==================================================================================================================================== W. R. GRACE & CO. AND SUBSIDIARIES THREE MONTHS ENDED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED) MARCH 31, - ------------------------------------------------------------------------------------------------------------------------------------ In millions, except per share amounts 2005 2004 ------------------------------------------ Net sales.......................................................................... $603.2 $518.5 ------------------------------------------ Cost of goods sold, exclusive of depreciation and amortization shown separately below.......................................................................... 392.7 331.2 Selling, general and administrative expenses, exclusive of net pension expense shown separately below......................................................... 119.3 101.5 Depreciation and amortization ..................................................... 28.8 27.2 Research and development expenses ................................................. 15.1 12.7 Net pension expense ............................................................... 17.6 13.5 Interest expense and related financing costs ...................................... 14.6 3.9 Provision for environmental remediation ........................................... -- -- Provision for asbestos-related litigation, net of insurance........................ -- -- Other (income) expense............................................................. (6.1) (3.2) ------------------------------------------ 582.0 486.8 ------------------------------------------ Income (loss) before Chapter 11 expenses, income taxes, and minority interest...... 21.2 31.7 Chapter 11 expenses, net .......................................................... (6.0) (4.5) Benefit from (provision for) income taxes.......................................... (8.6) (10.9) Minority interest in consolidated entities......................................... (3.5) (0.5) ------------------------------------------ NET INCOME (LOSS) ............................................................. $ 3.1 $ 15.8 ==================================================================================================================================== BASIC EARNINGS (LOSS) PER COMMON SHARE: Net income (loss) ................................................................. $ 0.05 $ 0.24 Average number of basic shares .................................................... 66.6 65.6 DILUTED EARNINGS (LOSS) PER COMMON SHARE: Net income (loss) ................................................................. $ 0.05 $ 0.24 Average number of diluted shares................................................... 67.3 65.8 ==================================================================================================================================== The Notes to Consolidated Financial Statements are an integral part of these statements. I-2 ==================================================================================================================================== W. R. GRACE & CO. AND SUBSIDIARIES THREE MONTHS ENDED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) MARCH 31, - ------------------------------------------------------------------------------------------------------------------------------------ In millions 2005 2004 --------------------------------------- OPERATING ACTIVITIES Income (loss) before Chapter 11 expenses, income taxes, and minority interest.............................................................................. $ 21.2 $ 31.7 Reconciliation to cash provided by operating activities: Depreciation and amortization........................................................ 28.8 27.2 Interest accrued on pre-petition liabilities subject to compromise................... 13.3 2.7 Loss (gain) on sales of investments and disposals of assets.......................... (0.9) 0.2 Net pension expense.................................................................. 17.6 13.5 Payments to fund defined benefit pension arrangements................................ (3.0) (2.7) Cash paid for litigation settlement.................................................. (8.3) -- Provision for environmental remediation.............................................. -- -- Provision for asbestos-related litigation, net of insurance.......................... -- -- Net income from life insurance policies.............................................. (1.3) (1.5) Bad debt expense..................................................................... 0.6 0.5 Payments under postretirement benefit plans.......................................... (2.3) (2.6) Expenditures for environmental remediation........................................... (1.2) (2.9) Expenditures for retained obligations of divested businesses......................... (0.3) (0.4) Changes in assets and liabilities, excluding effect of businesses acquired/divested and foreign currency translation: Working capital items............................................................ (75.2) (33.2) Other accruals and non-cash items................................................ (10.9) 0.5 --------------------------------------- NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES BEFORE INCOME (21.9) 33.0 TAXES AND CHAPTER 11 EXPENSES...................................................... Chapter 11 expenses paid, net............................................................. (4.4) (2.0) Income taxes paid, net of refunds......................................................... (5.4) (10.3) --------------------------------------- NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES................................. (31.7) 20.7 --------------------------------------- INVESTING ACTIVITIES Capital expenditures...................................................................... (12.4) (9.1) Businesses acquired, net of cash acquired................................................. (2.2) -- Proceeds from termination of life insurance policies...................................... 14.8 -- Net investment in life insurance policies................................................. -- (4.6) Proceeds from life insurance policies..................................................... 2.0 5.3 Proceeds from sales of investments and disposals of assets................................ 0.1 0.1 --------------------------------------- NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES................................. 2.3 (8.3) --------------------------------------- FINANCING ACTIVITIES Net payment of loans secured by cash value of life insurance.............................. (0.5) (1.3) Borrowings under credit facilities, net of repayments..................................... (2.0) 8.9 Borrowings under debtor-in-possession facility, net of fees............................... (0.6) (0.5) Repayments of borrowings under debtor-in-possession facility.............................. -- -- Exercise of stock options................................................................. 3.0 -- --------------------------------------- NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES................................. (0.1) 7.1 --------------------------------------- Effect of currency exchange rate changes on cash and cash equivalents..................... (6.1) (3.4) --------------------------------------- INCREASE IN CASH AND CASH EQUIVALENTS................................................ (35.6) 16.1 Cash and cash equivalents, beginning of period............................................ 510.4 309.2 --------------------------------------- Cash and cash equivalents, end of period.................................................. $474.8 $325.3 ==================================================================================================================================== The Notes to Consolidated Financial Statements are an integral part of these statements. I-3 =================================================================================================================================== W. R. GRACE & CO. AND SUBSIDIARIES MARCH 31, DECEMBER 31, CONSOLIDATED BALANCE SHEETS (UNAUDITED) 2005 2004 - ----------------------------------------------------------------------------------------------------------------------------------- In millions, except par value and shares ASSETS CURRENT ASSETS Cash and cash equivalents................................................................. $ 474.8 $ 510.4 Trade accounts receivable, less allowance of $6.0 (2004 - $5.8)........................... 400.1 390.9 Inventories............................................................................... 258.3 248.3 Deferred income taxes..................................................................... 16.9 16.3 Other current assets...................................................................... 56.7 62.6 ------------------------------------- TOTAL CURRENT ASSETS................................................................. 1,206.8 1,228.5 Properties and equipment, net of accumulated depreciation and amortization of $1,326.9 (2004 - $1,325.9)........................................... 620.5 645.3 Goodwill.................................................................................. 108.7 111.7 Cash value of life insurance policies, net of policy loans................................ 81.0 96.0 Deferred income taxes..................................................................... 664.6 667.4 Asbestos-related insurance................................................................ 500.0 500.0 Other assets.............................................................................. 282.0 290.0 ------------------------------------- TOTAL ASSETS......................................................................... $3,463.6 $3,538.9 ===================================== LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) LIABILITIES NOT SUBJECT TO COMPROMISE CURRENT LIABILITIES Debt payable within one year.............................................................. $ 10.1 $ 12.4 Accounts payable.......................................................................... 147.0 146.0 Income taxes payable...................................................................... 10.0 7.7 Other current liabilities................................................................. 163.5 221.5 ------------------------------------- TOTAL CURRENT LIABILITIES............................................................ 330.6 387.6 Debt payable after one year ........................................................... 1.1 1.1 Deferred income taxes..................................................................... 60.6 64.1 Unfunded defined benefit pension liability................................................ 431.1 424.9 Other liabilities......................................................................... 68.8 75.3 ------------------------------------- TOTAL LIABILITIES NOT SUBJECT TO COMPROMISE.......................................... 892.2 953.0 LIABILITIES SUBJECT TO COMPROMISE - NOTE 2................................................ 3,200.1 3,207.7 ------------------------------------- TOTAL LIABILITIES.................................................................... 4,092.3 4,160.7 ------------------------------------- COMMITMENTS AND CONTINGENCIES SHAREHOLDERS' EQUITY (DEFICIT) Common stock issued, par value $0.01; 300,000,000 shares authorized; outstanding: 2005 - 66,905,496 (2004 - 66,395,721).................................. 0.8 0.8 Paid-in capital........................................................................... 423.5 426.5 Accumulated deficit....................................................................... (570.1) (573.2) Treasury stock, at cost: shares: 2005 - 10,074,264; (2004 - 10,584,039)................... (119.9) (125.9) Accumulated other comprehensive loss...................................................... (363.0) (350.0) ------------------------------------- TOTAL SHAREHOLDERS' EQUITY (DEFICIT)................................................. (628.7) (621.8) ------------------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT)................................. $3,463.6 $3,538.9 =================================================================================================================================== The Notes to Consolidated Financial Statements are an integral part of these statements. I-4 ==================================================================================================================================== W. R. GRACE & CO. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT) (UNAUDITED) ==================================================================================================================================== Accumulated TOTAL Common Stock Other SHAREHOLDERS' and Accumulated Treasury Comprehensive EQUITY In millions Paid-in Capital Deficit Stock Loss (DEFICIT) - ------------------------------------------------------------------------------------------------------------------------------------ BALANCE, DECEMBER 31, 2004............ $ 427.3 $ (573.2) $ (125.9) $ (350.0) $ (621.8) Net income............................ -- 3.1 -- -- 3.1 Stock plan activity .................. (3.0) -- 6.0 -- 3.0 Other comprehensive loss.............. -- -- -- (13.0) (13.0) ------------------------------------------------------------------------------------------- BALANCE, MARCH 31, 2005............... $ 424.3 $ (570.1) $ (119.9) $ (363.0) $ (628.7) ==================================================================================================================================== ==================================================================================================================================== W. R. GRACE & CO. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS) THREE MONTHS ENDED (UNAUDITED) MARCH 31, ==================================================================================================================================== In millions 2005 2004 ------------------------ --------------------- NET INCOME (LOSS)................................................................ $ 3.1 $ 15.8 OTHER COMPREHENSIVE INCOME (LOSS): Foreign currency translation adjustments...................................... (13.0) (5.0) ------------------------ --------------------- COMPREHENSIVE INCOME (LOSS)...................................................... $ (9.9) $ 10.8 ===================================================================================== ======================== ===================== The Notes to Consolidated Financial Statements are an integral part of these statements. I-5 W. R. GRACE & CO. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING AND FINANCIAL REPORTING POLICIES W. R. Grace & Co., through its subsidiaries, is engaged in specialty chemicals and specialty materials businesses on a worldwide basis through two business segments: "Davison Chemicals," which includes two product groups - refining technologies and specialty materials; and "Performance Chemicals," which includes three product groups - specialty construction chemicals, building materials, and sealants and coatings. W. R. Grace & Co. conducts substantially all of its business through a direct, wholly owned subsidiary, W. R. Grace & Co.-Conn. ("Grace-Conn."). Grace-Conn. owns substantially all of the assets, properties and rights of W. R. Grace & Co. on a consolidated basis, either directly or through subsidiaries. As used in these notes, the term "Company" refers to W. R. Grace & Co. The term "Grace" refers to the Company and/or one or more of its subsidiaries and, in certain cases, their respective predecessors. VOLUNTARY BANKRUPTCY FILING - In response to a sharply increasing number of asbestos-related personal injury claims, on April 2, 2001 (the "Filing Date"), W. R. Grace & Co. and 61 of its United States subsidiaries and affiliates, including Grace-Conn. (collectively, the "Debtors"), filed voluntary petitions for reorganization (the "Filing") under Chapter 11 of the United States Bankruptcy Code ("Chapter 11" or the "Bankruptcy Code") in the United States Bankruptcy Court for the District of Delaware (the "Bankruptcy Court"). The cases were consolidated and are being jointly administered under case number 01-01139 (the "Chapter 11 Cases"). Grace's non-U.S. subsidiaries and certain of its U.S. subsidiaries were not included in the Filing. During 2000 and the first quarter of 2001, Grace experienced several adverse developments in its asbestos-related litigation, including: a significant increase in personal injury claims, higher than expected costs to resolve personal injury and certain property damage claims, and class action lawsuits alleging damages from a former attic insulation product (Zonolite Attic Insulation or "ZAI"). After a thorough review of these developments, the Board of Directors of Grace concluded on April 2, 2001 that a federal court-supervised Chapter 11 process provided the best forum available to achieve fairness in resolving these claims. Under Chapter 11, the Debtors have continued to operate their businesses as debtors-in-possession under court protection from creditors and claimants, while using the Chapter 11 process to develop and implement a plan for addressing the asbestos-related claims. Since the Filing, all motions necessary to conduct normal business activities have been approved by the Bankruptcy Court. (See Note 2 for Chapter 11 Related Information.) BASIS OF PRESENTATION - The interim Consolidated Financial Statements presented herein are unaudited and should be read in conjunction with the Consolidated Financial Statements presented in the Company's 2004 Annual Report on Form 10-K. Such interim Consolidated Financial Statements reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of the results of the interim periods presented; all such adjustments are of a normal recurring nature. Potential accounting adjustments discovered during normal reporting and accounting processes are evaluated on the basis of materiality, both individually and in the aggregate, and are recorded in the accounting period discovered, unless a restatement of a prior period is necessary. All significant intercompany accounts and transactions have been eliminated. The results of operations for the three-month interim period ended March 31, 2005 are not necessarily indicative of the results of operations for the year ending December 31, 2005. RECLASSIFICATIONS - Certain amounts in prior years' Consolidated Financial Statements have been reclassified to conform to the 2005 presentation. USE OF ESTIMATES - The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires that management make estimates and assumptions affecting the assets and liabilities reported at the date of the Consolidated Financial Statements, and the revenues and expenses reported for the periods presented. Actual amounts could differ from those estimates. Changes in estimates are recorded in the period identified. Grace's accounting measurements that are most affected by management's estimates of future events are: o Contingent liabilities such as asbestos-related matters (see Notes 2 and 3), environmental remediation (see Note 12), income taxes (see Note 12), and litigation related to retained obligations of divested businesses and discontinued operations. o Pension and postretirement liabilities that depend on assumptions regarding discount rates and/or total returns on invested funds. (See Note 13.) I-6 o Depreciation and amortization periods for long-lived assets, including property and equipment, intangible, and other assets. o Realization values of various assets such as net deferred tax assets, trade receivables, inventories, insurance receivables, and goodwill. The accuracy of these and other estimates may also be materially affected by the uncertainties arising under Grace's Chapter 11 proceeding. EFFECT OF NEW ACCOUNTING STANDARDS - In December 2004, the Financial Accounting Standards Board ("FASB") revised Statement of Financial Accounting Standards ("SFAS") No. 123, "Share-Based Payment," to require companies to measure and recognize in operations the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value. The provisions of this standard are effective as of the beginning of the first annual reporting period that begins after June 15, 2005. Grace believes that this standard will not have a material impact on the Consolidated Financial Statements. In November 2004, the FASB issued SFAS No. 151, "Inventory Costs - an Amendment of ARB No. 43, Chapter 4," to provide clarification that abnormal amounts of idle facility expense, freight, handling costs, and wasted material be recognized as current-period charges. In addition, this standard requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. The provisions of this standard are effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Grace is currently evaluating the impact the standard will have on the Consolidated Financial Statements. STOCK INCENTIVE PLANS - SFAS No. 123 permits the Company to follow the measurement provisions of Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees," and not recognize compensation expense for its stock-based incentive plans. To determine compensation cost under SFAS No. 123, the fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model. No compensation cost was recognized for the Company's stock-based incentive compensation plans in pro forma net income for the three-month period ended March 31, 2005 due to the fact that all prior grants had vested and were fully expensed in prior periods. There were no option grants in the first quarter of 2005 or the year ended 2004. 2. CHAPTER 11 RELATED INFORMATION PLAN OF REORGANIZATION - On November 13, 2004 Grace filed a plan of reorganization, as well as several associated documents, including a disclosure statement, with the Bankruptcy Court. On January 13, 2005, Grace filed an amended plan of reorganization (the "Plan") and related documents to address certain objections of creditors and other interested parties. The amended Plan is supported by committees representing general unsecured creditors and equity holders, but is not supported by committees representing asbestos personal injury claimants and asbestos property damage claimants. Under the terms of the Plan, a trust would be established under Section 524(g) of the Bankruptcy Code to which all pending and future asbestos-related claims would be channeled for resolution. Grace has requested that the Bankruptcy Court conduct an estimation hearing to determine the amount that would need to be paid into the trust on the effective date of the Plan to satisfy the estimated liability for each class of asbestos claimants and trust administration costs and expenses over time. The Plan provides that Grace's asbestos-related liabilities would be satisfied using cash and securities from Grace and third parties. The Plan will become effective only after a vote of eligible creditors and with the approval of the Bankruptcy Court and the U.S. District Court for the District of Delaware. Votes on the Plan may not be solicited until the Bankruptcy Court approves the disclosure statement. The Debtors have received extensions of their exclusive right to propose a plan of reorganization through May 24, 2005, and extensions of the Debtors' exclusive right to solicit acceptances of a plan of reorganization through July 24, 2005. Under the terms of the Plan, Grace would satisfy claims under the Chapter 11 cases as follows: Asbestos-Related Claims and Costs - --------------------------------- A trust would be established under Section 524(g) of the Bankruptcy Code to which all pending and future asbestos-related claims would be channeled for resolution. The trust would utilize specified trust distribution procedures to satisfy the following allowed asbestos-related claims and costs: 1. Personal injury claims that meet specified exposure and medical criteria (Personal Injury-Symptomatic Eligible or "PI-SE" Claims) - In order to qualify for this class, claimants would have to prove that their health is impaired from meaningful exposure I-7 to asbestos-containing products formerly manufactured by Grace. 2. Personal injury claims that do not meet the exposure and medical criteria necessary to qualify as PI-SE Claims (Personal Injury-Asymptomatic and Other or "PI-AO" Claims) - This class would contain all asbestos-related personal injury claims against Grace that do not meet the specific requirements to be PI-SE Claims but do meet certain other specified exposure and medical criteria. 3. Property damage claims, including claims related to ZAI ("PD Claims") - In order to qualify for this class, claimants would have to prove Grace liability for loss of property value or remediation costs related to asbestos-containing products formerly manufactured by Grace. 4. Trust administration costs and legal expenses The pending asbestos-related legal proceedings are described in "Asbestos-Related Litigation" (see Note 3). The claims arising from such proceedings would be subject to this classification process as part of the Plan. Grace has requested that the Bankruptcy Court conduct estimation hearings to determine the amounts that would need to be paid into the trust on the effective date of the Plan to satisfy the estimated liability for each class of asbestos claimants and trust administration costs and expenses over time. The amounts to fund PI-SE Claims, PD Claims and the expense of trust administration would be capped at the amount determined through the estimation hearing; therefore, after initial funding of the asbestos trust, Grace would have no further obligation for these claims and costs. Amounts required to fund PI-AO Claims would not be capped, so if the amount funded in respect thereof later proved to be inadequate, Grace would be responsible for contributing additional funds into the asbestos trust to satisfy PI-AO Claims. Grace does not expect the estimation process to be completed before mid-2006. Asbestos personal injury claimants would have the option either to litigate their claims against the trust in federal court in Delaware or, if they meet specified eligibility criteria, accept a settlement amount based on the severity of their condition. Asbestos property damage claimants would be required to litigate their claims against the trust in federal court in Delaware. The Plan provides that, as a condition precedent to confirmation, the maximum estimated aggregate funding amount for all asbestos-related liabilities (PI-SE, PI-AO and PD including ZAI) and trust administration costs and expenses as determined by the Bankruptcy Court cannot exceed $1,613 million, which Grace believes would fund over $2 billion in claims, costs and expenses over time. The PI-SE Claims, the PD Claims and the related trust administration costs and expenses would be funded with (1) $512.5 million in cash (plus interest at 5.5% compounded annually from December 21, 2002) and nine million shares of common stock of Sealed Air Corporation ("Sealed Air") pursuant to the terms of a settlement agreement resolving asbestos-related and fraudulent transfer claims against Sealed Air, and (2) Grace common stock. The amount of Grace common stock required to satisfy these claims will depend on the liability measures approved by the Bankruptcy Court and the value of the Sealed Air settlement, which changes daily with the accrual of interest and the trading value of Sealed Air stock. The Sealed Air settlement agreement remains subject to Bankruptcy Court approval and the fulfillment of specified conditions. The PI-AO Claims would be funded with warrants exercisable for that number of shares of Grace common stock which, when added to the shares issued directly to the trust on the effective date of the Plan, would represent 50.1% of Grace's voting securities. If the common stock issuable upon exercise of the warrants is insufficient to pay all PI-AO Claims (the liability for which is uncapped under the Plan), then Grace would pay any additional liabilities in cash. Other Claims - ------------ The Plan provides that all allowed claims other than those covered under the asbestos trust would be paid 100% in cash (if such claims qualify as administrative or priority claims) or 85% in cash and 15% in Grace common stock (if such claims qualify as general unsecured claims). Grace estimates that claims with a recorded value of approximately $1,264 million, including interest accrued through March 31, 2005, would be satisfied in this manner at the effective date of the Plan. Grace would finance these payments with cash on hand, cash from Fresenius Medical Care Holdings, Inc. ("Fresenius") paid in settlement of asbestos and other Grace-related claims, new Grace debt, and Grace common stock. Grace would satisfy other non-asbestos related liabilities and claims (primarily certain environmental, tax, pension and retirement medical obligations) as they become due and payable over time. Proceeds from available product liability insurance applicable to asbestos-related claims would supplement operating cash flow to service new debt and liabilities not paid on the effective date of the Plan. I-8 Effect on Grace Common Stock - ---------------------------- The Plan provides that Grace common stock will remain outstanding at the effective date of the Plan, but that the interests of existing shareholders would be subject to dilution by additional shares of common stock issued under the Plan. In addition, in order to preserve significant tax benefits from net operating loss carryforwards ("NOLs"), which are subject to elimination or limitation in the event of a change in control (as defined by the Internal Revenue Code) of Grace, the Plan places restrictions on the purchase of Grace common stock. The restrictions would prohibit (without the consent of Grace), for a period of three years, a person or entity from acquiring more than 4.75% of the outstanding Grace common stock or, for those persons already holding more than 4.75%, prohibit them from increasing their holdings. The Bankruptcy Court has also approved the trading restrictions described above until the effective date of the Plan. Grace intends to address all pending and future asbestos-related claims and all other pre-petition claims as outlined in the Plan. However, Grace may not be successful in obtaining approval of the Plan by the Bankruptcy Court and other interested parties. Instead, a materially different plan of reorganization may ultimately be approved and, under the ultimate plan of reorganization, the interests of the Company's shareholders could be substantially diluted or cancelled. The value of Grace common stock following a plan of reorganization, and the extent of any recovery by non-asbestos-related creditors, will depend principally on the allowed value of Grace's asbestos-related claims as determined by the Bankruptcy Court. OFFICIAL PARTIES TO GRACE'S CHAPTER 11 PROCEEDINGS - Three creditors' committees, two representing asbestos claimants and the third representing other unsecured creditors, and a committee representing shareholders have been appointed in the Chapter 11 Cases. These committees, and a legal representative of future asbestos claimants, have the right to be heard on all matters that come before the Bankruptcy Court and are likely to play important roles in the Chapter 11 Cases. The Debtors are required to bear certain costs and expenses of the committees and of the future asbestos claimants' representative, including those of their counsel and financial advisors. CLAIMS FILINGS - The Bankruptcy Court established a bar date of March 31, 2003 for claims of general unsecured creditors, asbestos-related property damage claims and medical monitoring claims related to asbestos. The bar date did not apply to asbestos-related personal injury claims or claims related to ZAI, which will be dealt with separately. Approximately 14,900 proofs of claim were filed by the bar date. Of these claims, approximately 9,400 were non-asbestos related, approximately 4,300 were for asbestos-related property damage, and approximately 1,000 were for medical monitoring. The medical monitoring claims were made by individuals who allege exposure to asbestos through Grace's products or operations. These claims, if sustained, would require Grace to fund ongoing health monitoring costs for qualified claimants. In addition, approximately 500 proofs of claim were filed after the bar date. Approximately 7,000 of the non-asbestos related claims involve claims by employees or former employees for future retirement benefits such as pension and retiree medical coverage. Grace views most of these claims as contingent and has proposed a plan of reorganization that would retain such benefits. The other non-asbestos related claims include claims for payment of goods and services, taxes, product warranties, principal and interest under pre-petition credit facilities, amounts due under leases and other contracts, leases and other executory contracts rejected in the Bankruptcy Court, environmental remediation, indemnification or contribution to actual or potential co-defendants in asbestos-related and other litigation, pending non-asbestos-related litigation, and non-asbestos-related personal injury. The Debtors' have analyzed the claims as filed and have found that many are duplicates, represent the same claim filed against more than one of the Debtors, lack any supporting documentation, or provide insufficient supporting documentation. As of March 31, 2005, the Debtors had filed with the Bankruptcy Court objections to 1,366 claims. Most of these objections were non-substantive (duplicates, no supporting documentation, late filed claims, etc.). Of such claims, 1,104 have been expunged, 202 have been resolved, 33 have been withdrawn, and the remainder will be addressed through the claims objection process and the dispute resolution procedures approved by the Bankruptcy Court. The Debtors expect to file objections to a substantial number of additional claims. Grace believes that its recorded liabilities for claims subject to the bar date represent a reasonable estimate of the ultimate allowable amount for claims that are not in dispute or have been submitted with sufficient information to both evaluate merit and estimate the value of the claim. The asbestos-related claims are considered as part of Grace's overall asbestos liability and are being accounted for in accordance with the conditions precedent under the Plan, as described in "Accounting Impact" below. As claims are resolved, or where better I-9 information becomes available and is evaluated, Grace will make adjustments to the liabilities recorded on its financial statements as appropriate. Any such adjustments could be material to its consolidated financial position and results of operations. LITIGATION PROCEEDINGS IN BANKRUPTCY COURT - In September 2000, Grace was named in a purported class action lawsuit filed in California Superior Court for the County of San Francisco, alleging that the 1996 reorganization involving a predecessor of Grace and Fresenius and the 1998 reorganization involving a predecessor of Grace and Sealed Air were fraudulent transfers. The Bankruptcy Court authorized the Official Committee of Asbestos Personal Injury Claimants and the Official Committee of Asbestos Property Damage Claimants to proceed with claims against Fresenius and Sealed Air on behalf of the Debtors' bankruptcy estate. On November 29, 2002, Sealed Air and Fresenius each announced that they had reached agreements in principle with such Committees to settle asbestos and fraudulent transfer claims related to such transactions (the "litigation settlement agreements"). Under the terms of the Fresenius settlement, subject to certain conditions, Fresenius would contribute $115.0 million to the Debtors' estate as directed by the Bankruptcy Court upon confirmation of the Debtors' plan of reorganization, subject to the fulfillment of specified conditions. In July 2003, the Fresenius settlement was approved by the Bankruptcy Court. Under the terms of the proposed Sealed Air settlement, Sealed Air would make a payment of $512.5 million (plus interest at 5.5% compounded annually, commencing on December 21, 2002) and nine million shares of Sealed Air common stock (valued at $467.5 million as of March 31, 2005), as directed by the Bankruptcy Court upon confirmation of the Debtors' plan of reorganization. The Sealed Air settlement remains subject to the approval of the Bankruptcy Court and the fulfillment of specified conditions. DEBT CAPITAL - All of the Debtors' pre-petition debt is in default due to the Filing. The accompanying Consolidated Balance Sheets reflect the classification of the Debtors' pre-petition debt within "liabilities subject to compromise." The Debtors have entered into a debtor-in-possession post-petition loan and security agreement with Bank of America, N.A. (the "DIP facility") in the aggregate amount of $250 million. The term of the DIP facility expires on April 1, 2006. ACCOUNTING IMPACT - The accompanying Consolidated Financial Statements have been prepared in accordance with Statement of Position 90-7 ("SOP 90-7"), "Financial Reporting by Entities in Reorganization Under the Bankruptcy Code," promulgated by the American Institute of Certified Public Accountants. SOP 90-7 requires that financial statements of debtors-in-possession be prepared on a going concern basis, which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business. However, as a result of the Filing, the realization of certain of the Debtors' assets and the liquidation of certain of the Debtors' liabilities are subject to significant uncertainty. While operating as debtors-in-possession, the Debtors may sell or otherwise dispose of assets and liquidate or settle liabilities for amounts other than those reflected in the Consolidated Financial Statements. Further, the ultimate plan of reorganization could materially change the amounts and classifications reported in the Consolidated Financial Statements. Pursuant to SOP 90-7, Grace's pre-petition liabilities that are subject to compromise are required to be reported separately on the balance sheet at an estimate of the amount that will ultimately be allowed by the Bankruptcy Court. As of March 31, 2005, such pre-petition liabilities include fixed obligations (such as debt and contractual commitments), as well as estimates of costs related to contingent liabilities (such as asbestos-related litigation, environmental remediation, and other claims). Obligations of Grace subsidiaries not covered by the Filing continue to be classified on the Consolidated Balance Sheets based upon maturity dates or the expected dates of payment. SOP 90-7 also requires separate reporting of certain expenses, realized gains and losses, and provisions for losses related to the Filing as reorganization items. Grace has not recorded any assets available to fund asbestos-related and other liabilities under the litigation settlements with Sealed Air and Fresenius, as such agreements are subject to conditions which, although expected to be met, have not been satisfied and approved by the Bankruptcy Court. The value available under these litigation settlement agreements as measured at March 31, 2005, was $1,161.5 million comprised of $115.0 million in cash from Fresenius and $1,046.5 million in cash and stock from Sealed Air. Grace's Consolidated Balance Sheets separately identify the liabilities that are "subject to compromise" as a result of the Chapter 11 proceedings. In Grace's case, "liabilities subject to compromise" represent pre-petition liabilities as determined under U.S. generally accepted accounting principles. Changes to the recorded amount of such liabilities will be based on developments in the Chapter 11 Cases and management's assessment of the I-10 claim amounts that will ultimately be allowed by the Bankruptcy Court. Changes to pre-petition liabilities subsequent to the Filing Date reflect: 1) cash payments under approved court orders; 2) the terms of Grace's proposed plan of reorganization, as discussed above, including the accrual of interest on pre-petition debt and the adjustment to Grace's recorded asbestos-related liability; 3) accruals for employee-related programs; and 4) changes in estimates related to other pre-petition contingent liabilities. Components of liabilities subject to compromise are as follows: =============================================================== (In millions) MARCH 31, December 31, (Unaudited) 2005 2004 =============================================================== Debt, pre-petition plus accrued interest......... $ 655.1 $ 645.8 Asbestos-related liability. 1,700.0 1,700.0 Income taxes............... 208.7 210.4 Environmental remediation.. 343.8 345.0 Postretirement benefits other than pension............. 115.3 118.9 Unfunded special pension arrangements............. 79.0 77.4 Retained obligations of divested businesses...... 19.5 25.1 Accounts payable .......... 31.3 31.3 Other accrued liabilities . 47.4 53.8 ------------------------------- TOTAL LIABILITIES SUBJECT TO COMPROMISE .............. $ 3,200.1 $ 3,207.7 =============================================================== Note that the unfunded special pension arrangements reflected above exclude non-U.S. plans and qualified U.S. plans that became underfunded subsequent to the Filing. Contributions to qualified U.S. plans are subject to Bankruptcy Court approval. CHANGE IN LIABILITIES SUBJECT TO COMPROMISE Set forth below is a reconciliation of the changes in pre-filing date liability balances for the period from the Filing Date through March 31, 2005. =============================================================== Cumulative (In millions) Since (Unaudited) Filing =============================================================== Balance, Filing Date.......................... $2,366.0 Cash disbursements and/or reclassifications under Bankruptcy Court orders: Freight and distribution order.......... (5.7) Trade accounts payable order............ (9.1) Other court orders including employee wages and benefits, sales and use tax, and customer programs................ (272.4) Expense/(income) items: Interest on pre-petition liabilities....... 166.4 Employee-related accruals.................. 21.4 Change in asbestos-related contingencies... 744.8 Change in estimate of environmental contingencies............................ 240.6 Change in estimate of income tax contingencies............................ (26.2) Balance sheet reclassifications............. (25.7) ------------ Balance, end of period........................ $3,200.1 =============================================================== Additional liabilities subject to compromise may arise due to the rejection of executory contracts or unexpired leases, or as a result of the allowance of contingent or disputed claims. CHAPTER 11 EXPENSES =============================================================== THREE MONTHS ENDED (In millions) MARCH 31, =============================================================== 2005 2004 ------------------------ Legal and financial advisory fees. $ 7.8 $ 4.8 Interest income .................. (1.8) (0.3) ------------------------ CHAPTER 11 EXPENSES, NET.......... $ 6.0 $ 4.5 =============================================================== Pursuant to SOP 90-7, interest income earned on the Debtors' cash balances must be offset against Chapter 11 expenses. I-11 CONDENSED FINANCIAL INFORMATION OF THE DEBTORS =============================================================== W. R. GRACE & CO. - CHAPTER 11 FILING ENTITIES DEBTOR-IN-POSSESSION STATEMENTS OF OPERATIONS THREE MONTHS ENDED (In millions) (Unaudited) MARCH 31, =============================================================== 2005 2004 -------------------------- Net sales, including intercompany $ 298.9 $ 269.4 -------------------------- Cost of goods sold, including intercompany, exclusive of depreciation and amortization shown separately below........ 202.8 194.4 Selling, general and administrative expenses, exclusive of net pension expense shown separately below 69.0 61.7 Research and development expenses....................... 9.6 8.6 Depreciation and amortization.... 14.9 14.5 Net pension expense.............. 13.2 10.2 Interest expense and related financing costs............... 14.4 3.8 Other (income) expense........... (12.0) (9.3) -------------------------- 311.9 283.9 -------------------------- Income (loss) before Chapter 11 expenses, income taxes, and equity in net income of non-filing entities........... (13.0) (14.5) Chapter 11 expenses, net......... (5.9) (4.5) Benefit from (provision for) income taxes................... (0.8) 2.5 -------------------------- Income (loss) before equity in net income of non-filing entities....................... (19.7) (16.5) Equity in net income of non-filing entities............ 22.8 32.3 -------------------------- NET INCOME (LOSS) .............. $ 3.1 $ 15.8 =============================================================== =============================================================== W. R. GRACE & CO. - CHAPTER 11 FILING ENTITIES DEBTOR-IN-POSSESSION CONDENSED STATEMENTS OF CASH FLOWS THREE MONTHS ENDED (In millions) (Unaudited) MARCH 31, =============================================================== 2005 2004 ------------------------ OPERATING ACTIVITIES Income (loss) before Chapter 11 expenses, income taxes, and equity in net income of non-filing entities $ (13.0) $ (14.5) Reconciliation to net cash provided by (used for) operating activities: Non-cash items, net............. 26.9 15.5 Contributions to defined benefit pension plans.................. (1.1) (1.1) Changes in other assets and liabilities, excluding the effect of businesses acquired/divested.............. (82.2) (9.3) ------------------------ NET CASH USED FOR OPERATING ACTIVITIES (69.4) (9.4) NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES............. 11.7 (6.0) NET CASH USED FOR FINANCING ACTIVITIES (1.1) (1.8) ------------------------ NET DECREASE IN CASH AND CASH EQUIVALENTS...................... (58.8) (17.2) Cash and cash equivalents, beginning of period........................ 340.0 120.5 ------------------------ Cash and cash equivalents, end of period........................... $ 281.2 $ 103.3 =============================================================== =============================================================== W. R. GRACE & CO. - CHAPTER 11 FILING ENTITIES DEBTOR-IN-POSSESSION BALANCE SHEETS MARCH 31, DECEMBER 31, (In millions) (Unaudited) 2005 2004 =============================================================== ASSETS CURRENT ASSETS Cash and cash equivalents .... $ 281.2 $ 340.0 Trade accounts receivable, net 112.1 111.6 Receivables from non-filing entities, net.............. 57.8 37.8 Inventories................... 83.3 76.9 Other current assets.......... 34.1 38.1 ------------------------------ TOTAL CURRENT ASSETS.......... 568.5 604.4 Properties and equipment, net. 352.0 359.9 Cash value of life insurance policies, net of policy loans........ 81.0 96.0 Deferred income taxes ........ 663.4 666.2 Asbestos-related insurance.... 500.0 500.0 Loans receivable from non-filing entities, net... 340.7 358.6 Investment in non-filing entities...................... 484.1 468.4 Other assets.................. 101.7 101.7 ------------------------------ TOTAL ASSETS.................. $ 3,091.4 $ 3,155.2 =============================================================== I-12 =============================================================== MARCH 31, DECEMBER 31, (In millions) (Unaudited) 2005 2004 =============================================================== LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) LIABILITIES NOT SUBJECT TO COMPROMISE Current liabilities............. $ 133.9 $ 187.5 Other liabilities............... 386.1 381.8 --------------------------- TOTAL LIABILITIES NOT SUBJECT TO COMPROMISE..................... 520.0 569.3 LIABILITIES SUBJECT TO COMPROMISE..................... 3,200.1 3,207.7 --------------------------- TOTAL LIABILITIES............... 3,720.1 3,777.0 SHAREHOLDERS' EQUITY (DEFICIT)...................... (628.7) (621.8) --------------------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) .............. $ 3,091.4 $ 3,155.2 =============================================================== In addition to Grace's financial reporting obligations as prescribed by the U.S. Securities and Exchange Commission ("SEC"), the Debtors are also required, under the rules and regulations of the Bankruptcy Code, to periodically file certain statements and schedules and a monthly operating report with the Bankruptcy Court. This information is available to the public through the Bankruptcy Court. This information is prepared in a format that may not be comparable to information in Grace's quarterly and annual financial statements as filed with the SEC. The monthly operating reports are not audited, do not purport to represent the financial position or results of operations of Grace on a consolidated basis, and should not be relied on for such purposes. 3. ASBESTOS-RELATED LITIGATION Grace is a defendant in property damage and personal injury lawsuits relating to previously sold asbestos-containing products. As of the Filing Date, Grace was a defendant in 65,656 asbestos-related lawsuits, 17 involving claims for property damage (one of which has since been dismissed), and the remainder involving 129,191 claims for personal injury. Due to the Filing, holders of asbestos-related claims are stayed from continuing to prosecute pending litigation and from commencing new lawsuits against the Debtors. Separate creditors' committees representing the interests of property damage and personal injury claimants, and a legal representative of future personal injury claimants, have been appointed in the Chapter 11 Cases. Grace's obligations with respect to present and future claims will be determined through the Chapter 11 process. PROPERTY DAMAGE LITIGATION - The plaintiffs in asbestos property damage lawsuits generally seek to have the defendants pay for the cost of removing, containing or repairing the asbestos-containing materials in the affected buildings. Each property damage case is unique in that the age, type, size and use of the building, and the difficulty of asbestos abatement, if necessary, vary from structure to structure. Information regarding product identification, the amount of product in the building, the age, type, size and use of the building, the legal status of the claimant, the jurisdictional history of prior cases and the court in which the case is pending has provided meaningful guidance as to the range of potential costs. Out of 380 asbestos property damage cases (which involved thousands of buildings) filed prior to the Filing Date, 140 were dismissed without payment of any damages or settlement amounts; judgments were entered in favor of Grace in nine cases (excluding cases settled following appeals of judgments in favor of Grace); judgments were entered in favor of the plaintiffs in eight cases (one of which is on appeal) for a total of $86.1 million; 207 property damage cases were settled for a total of $696.8 million; and 16 cases remain outstanding (including the one on appeal). Of the 16 remaining cases, eight relate to ZAI and eight relate to a number of former asbestos-containing products (two of which also are alleged to involve ZAI). Approximately 4,300 additional property damage claims were filed prior to the March 31, 2003 claims bar date established by the Bankruptcy Court. (The bar date did not apply to ZAI claims.) Such claims were reviewed in detail by Grace, categorized into claims with sufficient information to be evaluated or claims that require additional information and, where sufficient information existed, the estimated cost of resolution was considered as part of Grace's recorded asbestos-related liability. (Approximately 140 claims failed to provide sufficient information to permit an evaluation.) Eight of the ZAI cases were filed as purported class action lawsuits in 2000 and 2001. In addition, two purported class action lawsuits were filed in October 2004 with respect to persons and homes in Canada. These cases seek damages and equitable relief, including the removal, replacement and/or disposal of all such insulation. The plaintiffs assert that this product is in millions of homes and that the cost of removal could be several thousand dollars per home. As a result of the Filing, the eight U.S. cases have been transferred to the Bankruptcy Court. Based on Grace's investigation of the claims described in these lawsuits, and testing and analysis of this product by Grace and others, Grace believes that the product was and continues to be safe for its intended purpose and poses little or no threat to I-13 human health. The plaintiffs in the ZAI lawsuits (and the U.S. government in the Montana criminal proceeding described in Note 12) dispute Grace's position on the safety of ZAI. In July 2002, the Bankruptcy Court approved special counsel to represent, at the Debtors' expense, the ZAI claimants in a proceeding to determine certain threshold scientific issues regarding ZAI. On October 18, 2004, the Bankruptcy Court held a hearing on motions filed by the parties to address a number of important legal and factual issues regarding the ZAI claims, and has taken the motions under advisement. The Bankruptcy Court has indicated that it may require further proceedings with respect to the matters addressed in the motions. Given the very early stage of litigation, Grace's recorded asbestos-related liability at March 31, 2005 assumes the risk of loss from ZAI litigation is not probable. PERSONAL INJURY LITIGATION - Asbestos personal injury claimants allege adverse health effects from exposure to asbestos-containing products formerly manufactured by Grace. Claims are generally similar to each other, differing primarily in the type of asbestos-related illness allegedly suffered by the plaintiff. Claimants allege adverse health effects from exposure to asbestos-containing products formerly manufactured by Grace. Grace's cost to resolve such claims has been influenced by numerous variables, including the solvency of other former producers of asbestos containing products, cross-claims by co-defendants, the rate at which new claims are filed, the jurisdiction in which the claims are filed, and the defense and disposition costs associated with these claims. Cumulatively through the Filing Date, 16,354 asbestos personal injury lawsuits involving approximately 35,720 claims were dismissed without payment of any damages or settlement amounts (primarily on the basis that Grace products were not involved) and approximately 55,489 lawsuits involving approximately 163,698 claims were disposed of (through settlements and judgments) for a total of $645.6 million. As of the Filing Date, 129,191 claims for personal injury were pending against Grace. Grace believes that a substantial number of additional personal injury claims would have been received between the Filing Date and March 31, 2005 had such claims not been stayed by the Bankruptcy Court. ASBESTOS-RELATED LIABILITY - The total asbestos-related liability balance as of March 31, 2005 and December 31, 2004 was $1,700.0 million and is included in "liabilities subject to compromise." Grace adjusted its asbestos-related liability in the fourth quarter of 2004 based on its proposed plan of reorganization as discussed in Note 2. The amount recorded at December 31, 2004 includes the $1,613 million maximum amount reflected as a condition precedent to the Plan and $87 million related to pre-Chapter 11 contractual settlements and judgments included in the general unsecured claims. Under the Plan, Grace is requesting that the Bankruptcy Court determine the aggregate dollar amount, on a net present value basis (the "Funding Amount"), that must be funded on the effective date of the Plan into an asbestos trust (established under Section 524(g) of the Bankruptcy Code) to pay all allowed pending and future asbestos-related personal injury and property damage claims (including ZAI) and related trust administration costs and expenses on the later of the effective date of the Plan or when allowed. It is a condition to confirmation of the Plan that the Bankruptcy Court shall conclude that the Funding Amount is not greater than $1,613 million. This amount, which should be sufficient to fund over $2 billion in pending and future claims, is based in part on Grace's evaluation of (1) existing but unresolved personal injury and property damage claims, (2) actuarially-based estimates of future personal injury claims, (3) the risk of loss from ZAI litigation, (4) proposed claim payments reflected in the Plan, and (5) the cost of the trust administration and litigation. This amount may not be consistent with what the Bankruptcy Court may conclude would be a sufficient Funding Amount. Grace has requested that the Bankruptcy Court implement a process for estimating the Funding Amount, which will be primarily a function of the number of allowed property damage (including ZAI) and personal injury claims, and the amount payable per claim. Using this process, which involves the use of detailed claim forms, questionnaires, and expert testimony, Grace will seek to demonstrate that the vast majority of claims should not be allowed because they fail to establish any material property damage, health impairment or significant occupational exposure to asbestos from Grace's operations or products. Grace also will seek Bankruptcy Court approval of Grace's proposed payouts for allowed personal injury claims, which will vary depending upon the type of claim and/or the claimant's medical condition. If the Bankruptcy Court agrees with Grace's position on the number of, and the amounts to be paid in respect of, allowed personal injury and property damage claims, then Grace believes that the Funding Amount could be less than $1,613 million. However, this outcome is highly uncertain and will depend on a number of Bankruptcy Court rulings favorable to Grace's position. Conversely, the asbestos claimants committees and the future claimants representative have objected to Grace's proposed estimation process and are likely to continue to assert that Grace's asbestos-related liabilities are I-14 substantially higher than $1,613 million, and in fact are in excess of Grace's business value. If the Court accepts the position of the asbestos claimants committees, then any plan of reorganization likely would result in the loss of all or substantially all equity value by current shareholders. Therefore, due to the significant uncertainties of this process and asbestos litigation generally, Grace is not able to estimate a probable Funding Amount that would be accepted by the Bankruptcy Court. However, as Grace is willing to proceed with confirmation of the Plan with a Funding Amount of up to $1,613 million (assuming that other conditions precedent to confirmation of the Plan are satisfied, including the availability of funds from Sealed Air under the settlement agreement described in Note 2), during the fourth quarter of 2004, Grace accrued and took a charge of $714.8 million to increase its recorded asbestos-related liability to reflect the maximum amount allowed as a condition precedent under the Plan. This amount, plus $87.0 million for pre-Chapter 11 contractual settlements and judgments, brings the total recorded asbestos-related liability as of March 31, 2005 to $1,700 million. Any differences between the Plan as filed and as approved for confirmation could fundamentally change the accounting measurement of Grace's asbestos-related liability and that change could be material. INSURANCE RIGHTS - Grace previously purchased insurance policies that provide coverage for the 1962-1985 period with respect to asbestos-related lawsuits and claims. Since 1985, insurance coverage for asbestos-related liabilities has not been commercially available to Grace. Grace's primary insurance coverage is in the amount of $1 million per occurrence with annual aggregate product-liability limits ranging from $1 to $2 million. With one exception, coverage disputes regarding primary insurance policies have been settled, and the settlement amounts paid in full. Grace's excess coverage is for loss above certain levels. The levels vary from policy to policy, creating "layers" of excess coverage, some of which are triggered before others. As of March 31, 2005, after subtracting previous reimbursements by insurers and allowing for discounts pursuant to certain settlement agreements, there remains approximately $978 million of excess coverage from more than 30 presently solvent insurers. Grace has entered into settlement agreements with various excess insurance carriers. These settlements involve amounts paid and to be paid to Grace. The unpaid maximum aggregate amount available under these settlement agreements is approximately $495 million. With respect to asbestos-related personal injury claims, the settlement agreements generally require that the claims be spread over the claimant's exposure period and that each insurer pay a pro rata portion of each claim based on the amount of coverage provided during each year of the total exposure period. Presently, Grace has no agreements in place with insurers with respect to approximately $483 million of excess coverage, which is at layers of coverage that have not yet been triggered, but certain layers would be triggered if the Plan were approved at the recorded asbestos-related liability of $1,700 million. Grace believes that the ZAI claims also are covered under the settlement agreements and unsettled policies discussed above to the extent they relate to installations of ZAI occurring after July 1, 1973. Grace has approximately $355 million of excess coverage with insolvent or non-paying insurance carriers. (Non-paying carriers are those that, although technically not insolvent, are not currently meeting their obligations to pay claims.) Grace has filed and continues to file claims in the insolvency proceedings of insolvent carriers. Grace is currently receiving distributions from some of these insolvent carriers and expects to receive distributions in the future. Settlement amounts are recorded as income when received. Pursuant to settlements with primary-level and excess-level insurance carriers with respect to asbestos-related claims, Grace received no such payments during the first quarter of 2005 and $1.6 million during the prior year period. Grace estimates that, assuming an ultimate payout of asbestos-related claims equal to the recorded liability of $1,700 million, it should be entitled to approximately $500 million, on a net present value basis, of insurance recovery. 4. ACQUISITIONS AND JOINT VENTURES In the first quarter of 2005, Grace completed two business combinations for a total cash cost of $2.2 million as follows: o In February 2005, Grace acquired certain assets of Midland Dexter Venezuela, S.A. (Midevensa). Midevensa is a supplier of coatings and sealants for rigid packaging in the local and export markets of Latin America. I-15 o In March 2005, Grace acquired certain assets relating to the concrete admixtures business of Perstorp Peramin AB ("Perstorp") located in Sweden. Perstorp is a leading supplier of specialty chemicals and materials to the construction industry in Sweden and other Northern European countries. In the first quarter of 2004, Grace did not complete any business combinations. 5. OTHER (INCOME) EXPENSE Components of other (income) expense are as follows: =============================================================== OTHER (INCOME) EXPENSE THREE MONTHS ENDED (In millions) MARCH 31, =============================================================== 2005 2004 ------------ ----------- Investment income ................. $ (1.3) $ (1.5) Interest income ................... (0.7) (0.9) Net (gain) loss on sale of investments and disposals of assets (0.9) 0.2 Tolling revenue.................... (0.2) (0.3) Currency translation - intercompany loan............................. 14.9 -- Value of currency hedges........... (14.5) -- Other currency transaction effects. 0.2 1.4 Asbestos-related insurance ........ -- -- Other miscellaneous income......... (3.6) (2.1) ------------ ----------- TOTAL OTHER (INCOME) EXPENSE....... $ (6.1) $ (3.2) =============================================================== In March 2004, Grace began accounting for currency fluctuations on a (euro) 293 million intercompany loan between Grace's subsidiaries in the United States and Germany as a component of operating results instead of as a component of other comprehensive income. The change was prompted by new tax laws in Germany and Grace's cash flow planning for its Chapter 11 reorganization, which indicated that it is no longer reasonable to consider this loan as part of the permanent capital structure in Germany. In May 2004, Grace entered into a series of foreign currency hedge agreements to mitigate future currency fluctuations on the remaining loan balance. These hedge agreements have varying rates on notional amounts that coincide with loan repayments due periodically through June 2005. For the three months ended March 31, 2005, a $14.5 million hedge gain was recognized, offset by a $14.9 million foreign currency loss. These hedges are viewed as risk management instruments by Grace and are not used for trading or speculative purposes. 6. OTHER BALANCE SHEET ACCOUNTS MARCH 31, December 31, (In millions) 2005 2004 =============================================================== INVENTORIES Raw materials.................. $ 62.2 $ 62.4 In process..................... 35.0 36.1 Finished products.............. 180.0 166.7 General merchandise............ 33.2 32.2 Less: Adjustment of certain inventories to a last-in/first-out (LIFO) basis (52.1) (49.1) -------------- ------------- $ 258.3 $ 248.3 ================================== ============== ============= OTHER ASSETS Deferred pension costs......... $ 115.1 $ 119.5 Deferred charges .............. 50.9 49.9 Long-term receivables, less allowances of $0.7 (2004 - $0.8) ............... 8.3 8.3 Patents, licenses and other intangible assets, net....... 91.7 96.3 Pension-unamortized prior service cost................. 15.3 15.3 Investments in unconsolidated affiliates and other......... 0.7 0.7 -------------- ------------- $ 282.0 $ 290.0 ================================== ============== ============= OTHER CURRENT LIABILITIES Accrued compensation........... $ 53.2 $ 92.9 Deferred tax liability......... 1.2 1.2 Customer volume rebates........ 18.7 31.7 Accrued commissions............ 5.9 11.0 Accrued reorganization fees.... 13.0 11.4 Other accrued liabilities ..... 71.5 73.3 -------------- ------------- $ 163.5 $ 221.5 ================================== ============== ============= 7. LIFE INSURANCE Grace is the beneficiary of life insurance policies on certain current and former employees with a net cash surrender value of $81.0 million and $96.0 million at March 31, 2005 and December 31, 2004, respectively. The policies were acquired to fund various employee benefit programs and other long-term liabilities and are structured to provide cash flow (primarily tax-free) over an extended number of years. The following tables summarize activity in these policies for each of the three-month periods ended March 31, 2005 and 2004, and the components of net cash value at March 31, 2005 and December 31, 2004: I-16 =============================================================== LIFE INSURANCE - ACTIVITY SUMMARY THREE MONTHS ENDED (In millions) MARCH 31, =============================================================== 2005 2004 --------------- ------------- Earnings on policy assets..... $ 3.1 $ 9.1 Interest on policy loans...... (1.8) (7.6) Premiums...................... -- -- Policy loan repayments........ 0.5 1.3 Proceeds from termination of life insurance policies...... (14.8) -- Net investing activity........ (2.0) (0.7) --- ----------- -- ---------- Change in net cash value...... $ (15.0) $ 2.1 =============================================================== Tax-free proceeds received.... $ 2.0 $ 5.3 =============================================================== =============================================================== COMPONENTS OF NET CASH VALUE MARCH 31, December 31, (In millions) 2005 2004 =============================================================== Gross cash value.............. $ 104.7 $ 484.2 Principal - policy loans...... (22.9) (368.2) Accrued interest - policy loans ....................... (0.8) (20.0) --------------- ------------- Net cash value................ $ 81.0 $ 96.0 =============================================================== Insurance benefits in force... $ 193.6 $ 2,191.3 =============================================================== Grace's financial statements display income statement activity and balance sheet amounts on a net basis, reflecting the contractual interdependency of policy assets and liabilities. In January 2005, Grace surrendered and terminated most of these life insurance policies and received $14.8 million of net cash value from the termination. As a result of the termination, gross cash value of the policies was reduced by approximately $381 million and policy loans of approximately $365 million were satisfied. Grace's insurance benefits in force was reduced by approximately $2 billion to approximately $191 million as of December 31, 2004. See Note 12 for a discussion of a settlement agreement with the Internal Revenue Service ("IRS") with respect to tax contingencies of these life insurance policies and the tax consequences of terminating such policies. 8. DEBT =============================================================== COMPONENTS OF DEBT MARCH 31, December 31, (In millions) 2005 2004 =============================================================== DEBT PAYABLE WITHIN ONE YEAR Other short-term borrowings.. $ 10.1 $ 12.4 --------------- -------------- $ 10.1 $ 12.4 =============== ============== DEBT PAYABLE AFTER ONE YEAR DIP facility ................ $ -- $ -- Other short-term borrowings.. 1.1 1.1 --------------- -------------- $ 1.1 $ 1.1 =============== ============== DEBT SUBJECT TO COMPROMISE Bank borrowings.............. $ 500.0 $ 500.0 Other borrowings............. 14.7 15.0 Accrued interest............. 140.4 130.8 --------------- -------------- $ 655.1 $ 645.8 =============== ============== Annualized weighted average interest rates on total debt 6.0% 6.0% =============================================================== In April 2001, the Debtors entered into the DIP facility for a two-year term in the aggregate amount of $250 million. The DIP facility is secured by a priority lien on substantially all assets of the Debtors, and bears interest based on LIBOR. The Debtors have extended the term of the DIP facility through April 1, 2006. Grace had no outstanding borrowings under the DIP facility as of March 31, 2005; however, $28.8 million of standby letters of credit were issued and outstanding under the facility. The letters of credit, which reduce available funds under the facility, were issued mainly for trade-related matters such as performance bonds, and certain insurance and environmental matters. 9. SHAREHOLDERS' EQUITY (DEFICIT) The Company is authorized to issue 300,000,000 shares of common stock. Of the common stock unissued on March 31, 2005, approximately 7,160,862 shares were reserved for issuance pursuant to stock option and other stock incentive plans. In the first three months of 2005 and the year ended December 31, 2004, Grace did not grant any stock options. For additional information, see Notes 15 and 17 to the Consolidated Financial Statements in Grace's 2004 Form 10-K. 10. EARNINGS PER SHARE The following table shows a reconciliation of the numerators and denominators used in calculating basic and diluted earnings per share. =============================================================== EARNINGS PER SHARE THREE MONTHS ENDED (In millions, except per share amounts) MARCH 31, =============================================================== 2005 2004 ---------- ----------- NUMERATORS Net income........................ $ 3.1 $ 15.8 ========== =========== DENOMINATORS Weighted average common shares - basic calculation............... 66.6 65.6 Dilutive effect of employee stock options......................... 0.7 0.2 Weighted average common shares diluted calculation............. 67.3 65.8 ========== =========== BASIC EARNINGS PER SHARE............ $ 0.05 $ 0.24 ========== =========== DILUTED EARNINGS PER SHARE.......... $ 0.05 $ 0.24 =============================================================== 11. COMPREHENSIVE INCOME (LOSS) Grace's other comprehensive income (loss) consists entirely of foreign currency translation adjustments. The table below presents the pre-tax, tax and after tax amounts of Grace's other comprehensive income (loss) for the three months ended March 31, 2005 and 2004: I-17 =============================================================== After Pre-Tax Tax Tax (In millions) Amount Benefit Amount =============================================================== THREE MONTHS ENDED: March 31, 2005....... $ (13.0) $ -- $ (13.0) March 31, 2004....... $ (5.0) $ -- $ (5.0) =============================================================== The table below presents the components of Grace's accumulated other comprehensive loss at March 31, 2005 and December 31, 2004: =============================================================== COMPONENTS OF ACCUMULATED OTHER COMPREHENSIVE LOSS MARCH 31, December 31, (In millions) 2005 2004 =============================================================== Foreign currency translation $ (15.5) $ (2.5) Minimum pension liability . (347.5) (347.5) ---------------- -------------- Accumulated other comprehensive loss....... $ (363.0) $ (350.0) =============================================================== Grace is a global enterprise which operates in over 40 countries with local currency generally deemed to be the functional currency for accounting purposes. The foreign currency translation amount represents the adjustment necessary to translate the balance sheets valued in local currencies to the U.S. dollar as of the end of each year presented. The change in foreign currency translation at March 31, 2005 compared with December 31, 2004 is due to the strengthening of the U.S. dollar against most other reporting currencies. The decline in equity market returns in 2000-2002, coupled with a decline in interest rates from 2000-2004, as well as updated assumptions for expected life-spans and the longevity of Grace's active work force created a shortfall between the accounting measurement of Grace's obligations under certain of its qualified pension plans for U.S. employees and the market value of dedicated pension assets. This condition required Grace to record a minimum pension liability for these plans equal to the funding shortfall and to offset related deferred costs against shareholders' equity (deficit) at December 31, 2004. 12. COMMITMENTS AND CONTINGENT LIABILITIES ASBESTOS-RELATED LITIGATION - See Note 3 ENVIRONMENTAL REMEDIATION - Grace is subject to loss contingencies resulting from extensive and evolving federal, state, local and foreign environmental laws and regulations relating to the generation, storage, handling, discharge and disposition of hazardous wastes and other materials. Grace accrues for anticipated costs associated with investigative and remediation efforts where an assessment has indicated that a probable liability has been incurred and the cost can be reasonably estimated. These accruals do not take into account any discounting for the time value of money. Grace's environmental liabilities are reassessed whenever circumstances become better defined or remediation efforts and their costs can be better estimated. These liabilities are evaluated based on currently available information, including the progress of remedial investigation at each site, the current status of discussions with regulatory authorities regarding the method and extent of remediation at each site, existing technology, prior experience in contaminated site remediation and the apportionment of costs among potentially responsible parties. Grace expects that the funding of environmental remediation activities will be affected by the Chapter 11 proceedings. Grace's estimated environmental liabilities are included in "liabilities subject to compromise." At March 31, 2005, Grace's estimated liability for environmental investigative and remediation costs totaled $343.8 million, as compared with $345.0 million at December 31, 2004. The amount is based on funding and/or remediation agreements in place and Grace's best estimate of its cost for sites not subject to a formal remediation plan. Net cash expenditures charged against previously established reserves for the three months ended March 31, 2005 and 2004 were $1.2 million and $2.9 million, respectively. Vermiculite Related Matters From the 1920's until 1992, Grace (beginning in 1963) and previous owners conducted vermiculite mining and related activities near Libby, Montana. The mined vermiculite ore contained varying amounts of asbestos as an impurity, almost all of which was removed during processing. Expanded vermiculite was used in products such as fireproofing, insulation and potting soil. In November 1999, Region 8 of the Environmental Protection Agency ("EPA") began an investigation into alleged excessive levels of asbestos-related disease in the Libby population related to these former mining activities. This investigation led the EPA to undertake additional investigative activity and to carry out response actions in and around Libby. On March 30, 2001, the EPA filed a lawsuit in U.S. District Court for the District of Montana, Missoula Division (United States v. W. R. Grace & Company et al.) under the Comprehensive Environmental Response, Compensation and Liability Act for the recovery of costs allegedly incurred by the United States in response to the release I-18 or threatened release of asbestos in the Libby, Montana area relating to such former mining activities. These costs include cleaning and/or demolition of contaminated buildings, excavation and removal of contaminated soil, health screening of Libby residents and former mine workers, and investigation and monitoring costs. In this action, the EPA also sought a declaration of Grace's liability that would be binding in future actions to recover further response costs. In December 2002, the District Court granted the United States' motion for partial summary judgment on a number of issues that limited Grace's ability to challenge the EPA's response actions. In January 2003, a trial was held on the remainder of the issues, which primarily involved the reasonableness and adequacy of documentation of the EPA's cost recovery claims through December 31, 2001. On August 28, 2003, the District Court issued a ruling in favor of the United States that requires Grace to reimburse the government for $54.5 million (plus interest) in costs expended through December 2001, and for all appropriate future costs to complete the clean-up. Grace appealed the court's ruling to the Ninth Circuit Court of Appeals, which heard oral argument on February 7, 2005. No decision has been issued on the appeal. As a result of the District Court ruling and Grace's evaluation of estimated costs for remediation in and around Libby and at vermiculite processing sites currently or formerly operated by Grace, Grace's total estimated liability for vermiculite-related remediation at March 31, 2005 and December 31, 2004 was $204.1 million and $204.2 million, respectively. Grace's estimate of expected costs is based on public comments regarding the EPA's spending plans, discussions of spending forecasts with EPA representatives, analysis of other information made available from the EPA, and evaluation of probable remediation costs at vermiculite processing sites. However, the EPA's cost estimates have increased regularly and substantially over the course of this clean-up. Consequently, as the EPA's spending on these matters increases, Grace's liability for remediation will increase. Non-Vermiculite Related Matters At March 31, 2005 and December 31, 2004, Grace's estimated liability for remediation of sites not related to its former vermiculite mining and processing activities was $139.7 million and $140.8 million, respectively. This liability relates to Grace's current and former operations, including its share of liability for off-site disposal at facilities where it has been identified as a potentially responsible party. Grace's estimated liability is based upon an evaluation of claims for which sufficient information was available. As Grace receives new information and continues its claims evaluation process, its estimated liability may change materially. TAX MATTERS - On January 10, 2005, Grace received a corrected examination report from the Internal Revenue Service (the "IRS") for the 1993 - 1996 tax periods asserting, in the aggregate, approximately $90.9 million of proposed tax adjustments, plus accrued interest (the "Examination Report"). The most significant issue addressed in the Examination Report concerns corporate-owned life insurance ("COLI") policies. As discussed below, a settlement agreement relating to COLI was executed on January 20, 2005. The benefit of that settlement was not reflected in the Examination Report. Once reflected, Grace anticipates that the proposed tax adjustment will be reduced from approximately $90.9 million to approximately $77.5 million plus accrued interest. Other proposed adjustments include disallowance of research and development ("R&D") credits, general business credits and miscellaneous deductions. Subject to IRS revision of the Examination Report to reflect the benefit of the COLI settlement, Grace is in agreement with the IRS with respect to all proposed tax adjustments in the Examination Report with the exception of approximately $7.0 million of proposed adjustments relating to R&D credits. On April 14, 2005, Grace made a $90 million payment to the IRS with respect to federal taxes and accrued interest for the 1993-1996 tax periods, consistent with the expected revised Examination Report. Grace's estimate for state tax payments to be made for the 1990-1996 tax periods is approximately $27 million, of which approximately $18.5 million is expected to be paid in the near future. With respect to COLI, in 1988 and 1990, Grace acquired COLI policies and funded policy premiums in part using loans secured against policy cash surrender value. Grace claimed a total of approximately $258 million in deductions attributable to interest accrued on such loans through the 1998 tax year, after which such deductions were no longer permitted by law. The IRS disallowance of such interest deductions, beginning during the 1990-1992 federal tax audit, resulted in years of discussion until recently, when the issue was resolved in a settlement approved by the Bankruptcy Court, as described below. On January 20, 2005, Grace terminated the COLI policies and Grace, Fresenius, Sealed Air and the IRS entered into a COLI Closing Agreement. Under the COLI Closing Agreement, the government allowed 20% of the aggregate amount of the COLI interest deductions and Grace owes federal income tax and interest with I-19 respect to the remaining 80% of the COLI interest deductions disallowed. Grace estimates that the federal tax liability resulting from the COLI settlement is approximately $52.5 million, $10.4 million of which was paid in 2000 in connection with the 1990-1992 tax audit, and $30.8 million of which was paid in the April 14, 2005 payment in connection with the 1993-1996 federal tax audit discussed above. The remaining approximately $11.3 million of additional tax liability will be satisfied in connection with the 1997 and 1998 federal tax audits, which are still under examination by the IRS. The COLI Closing Agreement also provides that, with respect to the termination of the COLI policies, Grace will include 20% of the gain realized in taxable income, with the government exempting 80% of such gain from tax. As a result of the termination, Grace received $14.8 million in cash proceeds and will record income for tax purposes of approximately $60 million in 2005. It is anticipated that Grace will apply its net operating loss carryforwards to offset the taxable income generated from terminating the COLI policies, although alternative minimum taxes may apply. Grace's federal tax returns covering 1997 through 2001 are currently under examination by the IRS and subsequent years are open for future examination. The IRS has assessed additional federal income tax withholding and Federal Insurance Contributions Act taxes plus interest and related penalties for calendar years 1993 through 1998 against a Grace subsidiary that formerly operated a temporary staffing business for nurses and other health care personnel. The assessments, aggregating $61.9 million, were made in connection with a meal and incidental expense per diem plan for traveling health care personnel, which was in effect through 1999, the year in which Grace sold the business. (The statute of limitations has expired with respect to 1999.) The IRS contends that certain per diem reimbursements should have been treated as wages subject to employment taxes and federal income tax withholding. Grace contends that its per diem and expense allowance plans were in accordance with statutory and regulatory requirements, as well as other published guidance from the IRS. Grace has a right to indemnification from its former partner in the business for approximately 36% of any tax liability (including interest thereon) for the period from July 1996 through December 1998. The matter is currently pending in the United States Court of Claims. Grace has tentatively agreed with the Department of Justice and IRS on a settlement amount and certain other terms that would resolve the matter. The preliminary settlement is subject to the execution of written closing agreements with the IRS and a written settlement agreement with the Department of Justice, and to Bankruptcy Court approval. On October 22, 2004, President Bush signed the American Jobs Creation Act of 2004 (the "Jobs Act") into law. While Grace and its advisors are currently analyzing the many revisions to the tax laws enacted by the Jobs Act, Grace has focused primarily at this time on the potential impacts of the domestic manufacturing deductions and the foreign repatriation incentives. With respect to manufacturing, commencing in 2005, the Jobs Act phases in over a five-year period an annual manufacturing deduction of up to 9% on the lesser of a taxpayer's income from domestic manufacturing activities or taxable income. Given Grace's current U.S. net operating loss carryforward position, Grace will not be entitled to the special deduction. Therefore, Grace's 2004 effective tax rate does not reflect any benefit for the special deduction. With respect to foreign repatriation incentives, the Jobs Act provides an 85% dividends received deduction with respect to certain dividends received from a U.S. corporation's foreign subsidiaries. The dividends must be used to fund certain permitted domestic activities, as specified in the Jobs Act. These domestic activities include the building or improvement of infrastructure, research and development, and the financial stabilization of the corporation. As Grace currently understands the repatriation provision, companies in a net operating loss carryforward position would not be eligible to utilize foreign tax credits to offset U.S. taxes on foreign dividends eligible for benefits under the Jobs Act. Such dividends would be subject to cash taxes equal to approximately 5.25% of the dividend distributions. Therefore, Grace does not expect to elect the application of the Jobs Act to foreign dividend distributions. Instead, if Grace is unable to utilize foreign tax credits to offset the U.S. tax on these dividends, it will likely opt to utilize NOLs to offset the full 35% U.S. income tax. Grace will continue to monitor IRS pronouncements with respect to the Jobs Act and will reconsider its current position if the law is either clarified or amended to permit use of its foreign tax credits to offset the U.S. tax on qualifying dividend income. In order to preserve its rights under the Jobs Act, Grace will comply with its terms in repatriating dividends in 2005. Grace is closely tracking this new law and, if the government provides guidance permitting Grace to utilize foreign tax credits to offset U.S. taxes on dividend distributions, the company will likely elect the application of the Jobs Act. The dividend-received deduction is available to taxpayers for only a limited period of time, expiring after year-end 2005. I-20 Grace believes that the impact of probable tax return adjustments is adequately recognized as liabilities in its consolidated financial statements at March 31, 2005. PURCHASE COMMITMENTS - From time to time, Grace engages in purchase commitments in its various business activities, all of which are expected to be fulfilled with no material adverse consequences to Grace's operations or financial position. GUARANTEES AND INDEMNIFICATION OBLIGATIONS - Grace is a party to many contracts containing guarantees and indemnification obligations. These contracts primarily consist of: o Contracts providing for the sale of a former business unit or product line in which Grace has agreed to indemnify the buyer against liabilities arising prior to the closing of the transaction, including environmental liabilities. These liabilities are included in "liabilities subject to compromise" in the Consolidated Balance Sheets; o Guarantees of real property lease obligations of third parties, typically arising out of (a) leases entered into by former subsidiaries of Grace, or (b) the assignment or sublease of a lease by Grace to a third party. These obligations are included in "liabilities subject to compromise" in the Consolidated Balance Sheets; o Licenses of intellectual property by Grace to third parties in which Grace has agreed to indemnify the licensee against third party infringement claims; o Contracts entered into with third party consultants, independent contractors, and other service providers in which Grace has agreed to indemnify such parties against certain liabilities in connection with their performance. Based on historical experience and the likelihood that such parties will ever make a claim against Grace, such indemnification obligations are immaterial; and o Product warranties with respect to certain products sold to customers in the ordinary course of business. These warranties typically provide that product will conform to specifications. Grace generally does not establish a liability for product warranty based on a percentage of sales or other formula. Grace accrues a warranty liability on a transaction-specific basis depending on the individual facts and circumstances related to each sale. Both the liability and annual expense related to product warranties are immaterial to the Consolidated Financial Statements. FINANCIAL ASSURANCES - Financial assurances have been established for a variety of purposes, including insurance and environmental matters, asbestos settlements and appeals, trade-related commitments and other matters. At March 31, 2005, Grace had gross financial assurances issued and outstanding of $252.5 million, comprised of $135.2 million of gross surety bonds issued by various insurance companies and $117.3 million standby letters of credit and other financial assurances issued by various banks. MONTANA CRIMINAL PROCEEDING - On February 7, 2005, the United States Department of Justice announced the unsealing of a 10-count grand jury indictment against Grace and seven current or former senior level employees (United States of America v. W. R. Grace & Co. et al) relating to Grace's former vermiculite mining and processing activities in Libby, Montana. The indictment accuses the defendants of (1) conspiracy to violate environmental laws and obstruct federal agency proceedings; (2) violations of the federal Clean Air Act; (3) wire fraud in connection with the sale of allegedly contaminated properties; and (4) obstruction of justice. The U.S. District Court for the District of Montana has entered a scheduling order setting a trial date of September 11, 2006. Grace purchased the Libby mine in 1963 and operated it until 1990; vermiculite processing activities continued until 1992. The grand jury charges that the conspiracy took place from 1976 to 2002 and also charges that the alleged endangerment to the areas surrounding Libby continues to the present day. According to the U.S. Department of Justice, Grace could be subject to fines in an amount equal to twice the after-tax profit earned from its Libby operations or twice the alleged loss suffered by Libby victims, plus additional amounts for restitution to victims. The indictment alleges that such after tax profits were $140 million. Grace has categorically denied any criminal wrongdoing and intends to vigorously defend itself at trial. The U.S. Bankruptcy Court previously granted Grace's request to advance legal and defense costs to the employees, subject to a reimbursement obligation if it is later determined that the employees did not meet the standards for indemnification set forth under the appropriate state corporate law. For the three-month period ended March 31, 2005, total expense for Grace and the employees was $6.0 million. Grace is unable to assess whether the indictment, or any conviction resulting therefrom, will have a material adverse effect on the results of operations or financial condition of Grace or affect Grace's bankruptcy proceedings. However, Grace expects legal fees for its I-21 current and former employees defense could be several million dollars per quarter through the trial date. Such costs will be accounted for as incurred. ACCOUNTING FOR CONTINGENCIES - Although the outcome of each of the matters discussed above cannot be predicted with certainty, Grace has assessed its risk and has made accounting estimates as required under U.S. generally accepted accounting principles. As a result of the Filing, claims related to certain of the items discussed above will be addressed as part of Grace's Chapter 11 proceedings. Accruals recorded for such contingencies have been included in "liabilities subject to compromise" on the accompanying Consolidated Balance Sheets. The amounts of these liabilities as ultimately determined through the Chapter 11 proceedings could be materially different from amounts recorded at March 31, 2005. 13. PENSION PLANS AND OTHER POSTRETIREMENT BENEFIT PLANS PENSION PLANS - Grace maintains defined benefit pension plans covering employees of certain units who meet age and service requirements. Benefits are generally based on final average salary and years of service. Grace funds its U.S. qualified domestic pension plans ("qualified domestic pension plans") in accordance with U.S. federal laws and regulations. Non-U.S. pension plans are funded under a variety of methods, as required under local laws and customs. Grace also provides, through nonqualified plans, supplemental pension benefits in excess of qualified domestic pension plan limits imposed by federal tax law. These plans cover officers and higher-level employees and serve to increase the combined pension amount to the level that they otherwise would have received under the qualified domestic pension plans in the absence of such limits. The nonqualified plans are unfunded and Grace pays the costs of benefits as they are incurred. At the December 31, 2004 measurement date for Grace's defined benefit pension plans (the "Plans"), the accumulated benefit obligation ("ABO") was approximately $1,367 million as measured under U.S. generally accepted accounting principles. At March 31, 2005, Grace's recorded pension liability for underfunded plans was $510.1 million ($431.1 million included in liabilities not subject to compromise and $79.0 million related to supplemental pension benefits, included in "liabilities subject to compromise"). The recorded ABO liability reflects (1) the shortfall between dedicated assets and the ABO of underfunded plans ($304.1 million); and (2) the ABO of pay-as-you-go plans ($206.0 million). POST RETIREMENT BENEFITS OTHER THAN PENSIONS - Grace provides postretirement health care and life insurance benefits (referred to as other post-employment benefits or "OPEB") for retired employees of certain U.S. business units and certain divested units. The postretirement medical plan provides various levels of benefits to employees hired before 1991 and who retire from Grace after age 55 with at least 10 years of service. These plans are unfunded, and Grace pays a portion of the costs of benefits under these plans as they are incurred. Grace applies SFAS No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," which requires that the future costs of postretirement health care and life insurance benefits be accrued over the employees' years of service. Retirees and beneficiaries covered by the postretirement medical plan are required to contribute a minimum of 40% of the calculated premium for that coverage. During 2002, per capita costs under the retiree medical plans exceeded caps on the amount Grace was required to contribute under a 1993 amendment to the plan. As a result, for 2003 and future years, retirees will bear 100% of any increase in premium costs. For this reason, assumed health care cost trend rates are not used in the determination of Grace's OPEB expense. In December 2003, President Bush signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act") into law. The Act introduces a prescription drug benefit under Medicare ("Medicare Part D") as well as a federal subsidy to companies that provide a benefit that is at least actuarially equivalent (as defined in the Act) to Medicare Part D. On January 21, 2005, the Center for Medicare and Medicaid Services released the final regulations implementing the Act. Grace has determined that the prescription drug benefit under its postretirement health care plan is actuarially equivalent to the Medicare Part D benefit. Therefore, the accumulated postretirement benefit obligation (APBO) was remeasured as of January 21, 2005 to reflect the amount associated with the federal subsidy. The APBO was reduced by approximately $22.0 million and the net periodic benefit cost for 2005 will be reduced by approximately $2.8 million ($0.7 million for the three-month period ended March 31, 2005) due to the effect of the federal subsidy. I-22 The components of net periodic benefit cost for the three months ended March 31, 2005 and 2004 are as follows: =============================================================== COMPONENTS OF NET PERIODIC BENEFIT COST THREE MONTHS ENDED MARCH 31, - ---------------- ---------------------------------------------- 2005 2004 - ---------------- ---------------------- ----------------------- NON- Non- U.S. U.S. OPEB U.S. U.S. OPEB - ---------------- ------ ------- ------- ------- ------- ------- Service cost $ 4.2 $ 1.9 $ 0.2 $ 2.9 $ 1.5 $ 0.2 Interest cost 14.4 4.4 1.2 13.9 4.2 1.7 Expected return on plan assets (12.8) (4.0) -- (12.6) (3.8) -- Amortization of prior service cost...... 1.3 0.2 (3.2) 1.4 0.2 (3.2) Amortization of unrecognized actuarial loss...... 5.1 1.9 0.4 4.6 1.2 0.7 Net curtailment and settlement loss...... 1.0 -- -- -- -- -- ------ ------- ------- ------- ------- ------- NET PERIODIC BENEFIT COST...... $ 13.2 $ 4.4 $(1.4) $10.2 $ 3.3 $ (0.6) =============================================================== PLAN CONTRIBUTIONS AND FUNDING - Subject to the approval of the Bankruptcy Court, it is Grace's intention to satisfy its obligations under the Plans and to comply with all of the requirements of the Employee Retirement Income Security Act of 1974. In that regard, Grace will seek Bankruptcy Court approval to fund minimum required payments of approximately $60 million for the July 2005 to July 2006 period. However, there can be no assurance that the Bankruptcy Court will continue to approve arrangements to satisfy the funding needs of the Plans. Contributions to non-U.S. plans are not subject to Bankruptcy Court approval and Grace intends to fund such plans based on actuarial and trustee recommendations. 14. BUSINESS SEGMENT INFORMATION Grace is a global producer of specialty chemicals and specialty materials. It generates revenues from two business segments: Davison Chemicals, which consists of the refining technologies and specialty materials product groups; and Performance Chemicals, which consists of the specialty construction chemicals, building materials, and sealants and coatings product groups. Intersegment sales, eliminated in consolidation, are not material. The table below presents information related to Grace's business segments for the three-month period ended March 31, 2005 and 2004. Only those corporate expenses directly related to the segment are allocated for reporting purposes. All remaining corporate items are reported separately and labeled as such. =============================================================== BUSINESS SEGMENT DATA THREE MONTHS ENDED (In millions) MARCH 31, =============================================================== 2005 2004 --------- ---------- NET SALES Davison Chemicals.................... $ 334.7 $ 270.9 Performance Chemicals................ 268.5 247.6 --------- ---------- TOTAL.................................. $ 603.2 $ 518.5 ========= ========== PRE-TAX OPERATING INCOME Davison Chemicals.................... $ 37.7 $ 32.0 Performance Chemicals................ 27.3 27.6 --------- ---------- TOTAL.................................. $ 65.0 $ 59.6 =============================================================== The table below presents information related to the geographic areas in which Grace operated for each of the three-month periods ended March 31, 2005 and 2004, respectively. =============================================================== GEOGRAPHIC AREA DATA THREE MONTHS ENDED (In millions) MARCH 31, - ------------------------------------------ --------- ---------- 2005 2004 --------- ---------- NET SALES United States........................ $ 227.0 $ 202.3 Canada and Puerto Rico............... 33.2 22.9 --------- ---------- Total North America.................. 260.2 225.2 --------- ---------- Germany.............................. 28.4 28.2 Europe, other than Germany........... 192.8 165.2 --------- ---------- Total Europe......................... 221.2 193.4 --------- ---------- Asia Pacific......................... 88.1 72.7 Latin America........................ 33.7 27.2 --------- ---------- TOTAL.................................. $ 603.2 $ 518.5 =============================================================== The pre-tax operating income for Grace's business segments for each of the three-month periods ended March 31, 2005 and 2004, respectively, is reconciled below to income (loss) before Chapter 11 expenses, income taxes, and minority interest presented in the accompanying Consolidated Statements of Operations. =============================================================== RECONCILIATION OF BUSINESS SEGMENT DATA TO FINANCIAL STATEMENTS THREE MONTHS ENDED (In millions) MARCH 31, =============================================================== 2005 2004 ---------- --------- Pre-tax operating income - business segments............................. $ 65.0 $ 59.6 Minority interest ..................... 3.5 0.5 Gain (loss) on sale of investments and disposals of assets.................. 0.9 (0.2) Interest expense and related financing costs................................ (14.6) (3.9) Corporate costs........................ (25.3) (21.1) Other, net............................. (8.3) (3.2) ---------- --------- Income (loss) before Chapter 11 expenses, income taxes, and minority interest $ 21.2 $ 31.7 =============================================================== Corporate costs include expenses of corporate headquarters functions incurred in support of core operations, such as corporate financial and legal services, human resources management, communications and regulatory affairs. This item also includes certain pension and postretirement benefits, including the amortization of deferred costs that are considered a core operating expense but not allocated to business segments. I-23 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FINANCIAL SUMMARY FOR FIRST QUARTER 2005 The following is a summary analysis of key financial measures of Grace's performance for the quarter ended March 31, 2005 compared with the 2004 first quarter. o Grace's net income for each quarter has been determined primarily by: (1) the performance of Grace's businesses, which employ a growth and productivity strategy to maximize business performance, and (2) the impact of legal contingencies and other noncore liabilities. o The 80% decline in 2005 first quarter net income compared with the prior year quarter was a result of higher interest expense to reflect rates to which Grace's general unsecured creditors would be entitled in Grace's proposed plan of reorganization, higher pension expenses to reflect recent plan experience and capital market returns, and higher legal costs related to Chapter 11 and other litigation proceedings. o Sales increased 16.3% compared with the first quarter of 2004 as a result of (1) higher unit volumes (including incremental sales from acquisitions), (2) selling price increases to partially offset inflation in operating costs, and (3) favorable currency translation from a weaker U.S. dollar. o Pre-tax income from core operations increased 3.1%. The pre-tax results from core operations reflect added profit from higher sales and productivity improvements, which more than offset significant inflationary increases in the costs of raw materials, transportation fuels, energy and certain operating expenses. o Pre-tax operating income for the Davison Chemicals segment increased 17.8%, primarily as a result of improved sales volume, particularly in refining technologies products, and selling price increases implemented to offset higher raw materials and energy costs. o Pre-tax operating income for the Performance Chemicals segment was 1.1% lower than a strong prior year quarter. Operating income and margins were negatively affected by higher raw material and transportation costs, but were largely offset by improved volumes, selling price increases to mitigate inflation in raw material and transportation costs, and productivity gains. o Operating cash flow was a negative $31.7 million for the 2005 first quarter primarily due to payments of approximately $70 million for prior year performance incentives and customer volume rebates. Grace is attempting to resolve noncore liabilities and contingencies through a voluntary bankruptcy proceeding. The noncore liabilities include asbestos-related litigation, environmental remediation, tax disputes and business litigation. Grace's operating statements include periodic adjustments to account for changes in estimates of such liabilities and developments in its Chapter 11 proceeding. These liabilities and contingencies may result in continued volatility in net income in the future. DESCRIPTION OF CORE BUSINESS W. R. Grace & Co. and its subsidiaries are engaged in specialty chemicals and specialty materials businesses on a worldwide basis through two business segments: Davison Chemicals, which includes two main product groups - refining technologies and specialty materials; and Performance Chemicals, which includes three main product groups - specialty construction chemicals, building materials and sealants and coatings. GLOBAL SCOPE - Grace operates its business on a global scale with more than 60% of its revenue and 40% of its operating property outside the United States. Its business is conducted in more than 40 countries and in more than 20 currencies. The business segments are managed on a global basis, serving global markets, with currency fluctuations in relation to the U.S. dollar affecting reported earnings, net assets and cash flows. The table below shows the Grace business segments and product groups as a percentage of total Grace sales. =============================================================== PERCENTAGE OF THREE MONTHS ENDED TOTAL GRACE SALES MARCH 31, =============================================================== 2005 2004 ----------- ---------- Refining technologies............. 32.2% 28.0% Specialty materials............... 23.3% 24.2% ----------- ---------- DAVISON CHEMICALS................. 55.5% 52.2% ----------- ---------- Construction chemicals............ 21.5% 22.5% Building materials................ 11.1% 11.5% Sealants and coatings............. 11.9% 13.8% ----------- ---------- PERFORMANCE CHEMICALS............. 44.5% 47.8% ----------- ---------- TOTAL............................. 100.0% 100.0% =============================================================== REFINING TECHNOLOGIES includes: fluid cracking catalysts and additives used in petroleum refineries to convert distilled crude oil into transportation fuels and other petroleum-based products, and hydroprocessing I-24 catalysts used to upgrade heavy oils and remove certain impurities. Key external factors for refining technologies products are the economics of the refining industry, specifically the impacts of demand for transportation fuels and petrochemical products, and crude oil supply. SPECIALTY MATERIALS includes: silica-based engineered materials, which are used in a wide range of industrial and consumer applications such as paper, wood and coil coatings, food processing, plastics, adsorbents, and personal care products; life sciences materials and products which are used for biotechnology and pharmaceutical separations; and specialty catalysts, which are used in a variety of chemical processes and are essential components in the manufacture of polyethylene and polypropylene resins used in products such as plastic film, high-performance plastic pipe and other plastic parts. Sales of these products are affected most by general economic conditions, and specifically by the underlying growth rate of targeted end-use applications. CONSTRUCTION CHEMICALS AND BUILDING MATERIALS are used primarily by the non-residential and residential construction industries. Construction chemicals improve strength and aesthetics of finished concrete, control corrosion, and enhance the handling and application of concrete, and reduce the manufacturing cost and improve the quality of cement. Performance for this product group is affected by non-residential construction activity and, to a lesser extent, residential construction activity, which tend to lag the general economy in both decline and recovery. Building materials prevent water damage to structures and protect structural steel against collapse due to fire. The performance of this product group also is affected by non-residential construction activity and by residential construction and renovation activity, with greater lags than construction chemicals, reflecting longer lead times for large projects. Since building materials is largely a North American product group, it is most notably affected by the level of U.S. construction activity. SEALANTS AND COATINGS are used to seal beverage and food cans, and glass and plastic bottles, and to protect metal packaging from corrosion and the contents from the influences of metal. Although this product group is affected by general economic conditions, there is an ongoing shift in demand from metal and glass to plastic packaging for foods and beverages. This shift is causing a decline in can sealant usage, but provides opportunities to use closure sealants and other products for plastic packaging. CRITICAL ACCOUNTING ESTIMATES The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires that management make estimates and assumptions affecting the assets and liabilities reported at the date of the Consolidated Financial Statements, and the revenues and expenses reported for the periods presented. Actual amounts could differ from those estimates. Changes in estimates are recorded in the period identified. Grace's accounting measurements that are most affected by management's estimates of future events are: o Contingent liabilities such as asbestos-related matters (see Notes 2 and 3 to the Consolidated Financial Statements), environmental remediation (see Note 12 to the Consolidated Financial Statements), income taxes (see Note 12 to the Consolidated Financial Statements), and litigation related to retained obligations of divested businesses and discontinued operations. o Pension and postretirement liabilities that depend on assumptions regarding discount rates and/or total returns on invested funds. (See Note 13 to the Consolidated Financial Statements.) o Depreciation and amortization periods for long-lived assets, including property and equipment, intangible, and other assets. o Realization values of various assets such as net deferred tax assets, trade receivables, inventories, insurance receivables, and goodwill. The accuracy of these and other estimates may also be materially affected by the uncertainties arising under Grace's Chapter 11 proceeding. SUMMARY FINANCIAL INFORMATION AND METRICS Set forth on the next page is a chart that lists key operating statistics, and dollar and percentage changes for the three months ended March 31, 2005 and 2004. The chart should be referenced when reading management's discussion and analysis of the results of operations and financial condition. I-25 ==================================================================================================================================== ANALYSIS OF CONSOLIDATED OPERATIONS THREE MONTHS ENDED (In millions) MARCH 31, ==================================================================================================================================== $ Change % Change 2005 2004 Fav (Unfav) Fav (Unfav) -------------- ------------- ------------- ------------- NET SALES: Davison Chemicals................................................. $ 334.7 $ 270.9 $ 63.8 23.6% Performance Chemicals............................................. 268.5 247.6 20.9 8.4% -------------- ------------- ------------- ------------- TOTAL GRACE SALES - CORE OPERATIONS................................... $ 603.2 $ 518.5 $ 84.7 16.3% ==================================================================================================================================== PRE-TAX OPERATING INCOME: Davison Chemicals (1)............................................. $ 37.7 $ 32.0 $ 5.7 17.8% Performance Chemicals............................................. 27.3 27.6 (0.3) (1.1)% Corporate costs: Support functions............................................... (9.5) (8.0) (1.5) (18.8%) Pension, performance-related compensation, and other............ (15.8) (13.1) (2.7) (20.6%) -------------- ------------- ------------- ------------- Total Corporate costs............................................. (25.3) (21.1) (4.2) (19.9%) -------------- ------------- ------------- ------------- PRE-TAX INCOME FROM CORE OPERATIONS................................... 39.7 38.5 1.2 3.1% PRE-TAX LOSS FROM NONCORE ACTIVITIES.................................. (8.1) (4.3) (3.8) (88.4%) Interest expense................................................. (14.6) (3.9) (10.7) NM Interest income.................................................. 0.7 0.9 (0.2) (22.2%) -------------- ------------- ------------- ------------- INCOME (LOSS) BEFORE CHAPTER 11 EXPENSES AND INCOME TAXES............. 17.7 31.2 (13.5) (43.3%) Chapter 11 expenses, net.............................................. (6.0) (4.5) (1.5) (33.3%) Benefit from (provision for) income taxes............................. (8.6) (10.9) 2.3 21.1% -------------- ------------- ------------- ------------- NET INCOME (LOSS)..................................................... $ 3.1 $ 15.8 $ (12.7) (80.4%) ==================================================================================================================================== KEY FINANCIAL MEASURES: PRE-TAX INCOME FROM CORE OPERATIONS AS PERCENTAGE OF SALES: Davison Chemicals (1)............................................. 11.3% 11.8% NM (0.5) pts Performance Chemicals............................................. 10.2% 11.1% NM (0.9) pts Total Core Operations............................................. 6.6% 7.4% NM (0.8) pts PRE-TAX INCOME FROM CORE OPERATIONS BEFORE DEPRECIATION AND AMORTIZATION .................................................... $ 68.5 $ 65.7 $ 2.8 4.3% AS A PERCENTAGE OF SALES......................................... 11.4% 12.7% NM (1.3) pts ==================================================================================================================================== NET CONSOLIDATED SALES BY REGION: North America...................................................... $ 260.2 $ 225.2 $ 35.0 15.5% Europe............................................................. 221.2 193.4 27.8 14.4% Asia Pacific....................................................... 88.1 72.7 15.4 21.2% Latin America...................................................... 33.7 27.2 6.5 23.9% -------------- ------------- ------------- ------------- TOTAL................................................................. $ 603.2 $ 518.5 $ 84.7 16.3% ==================================================================================================================================== NM = Not meaningful (1) Pre-tax operating income for Davison Chemicals excludes minority interest related to the Advanced Refining Technologies joint venture. The above chart, as well as the financial information presented throughout this discussion, divides Grace's financial results between "core operations" and "noncore activities." Core operations comprise the financial results of Davison Chemicals, Performance Chemicals, and the costs of corporate activities that directly or indirectly support business operations. In contrast, noncore activities comprise all other events and transactions not directly related to the generation of operating revenue or the support of core operations and generally relate to Grace's former operations and products. Neither pre-tax income from core operations nor pre-tax income from core operations before depreciation and amortization purport to represent income or cash flow as defined under generally accepted accounting principles, and should not be considered an alternative to such measures as an indicator of Grace's performance. These measures are provided to distinguish operating results of Grace's current business base from results and related assets and liabilities of past businesses, discontinued products, and corporate legacies. I-26 GRACE OVERVIEW NET SALES - The following table identifies the quarter-over-quarter increase or decrease in sales attributable to changes in product volume, product price and/or mix, and the impact of foreign currency translation. ================================================================ NET SALES THREE MONTHS ENDED MARCH 31, 2005 AS A VARIANCE PERCENTAGE INCREASE (DECREASE) FROM ANALYSIS THREE MONTHS ENDED MARCH 31, 2004 ================================================================ VOLUME PRICE/MIX TRANSLATION TOTAL --------- ---------- ------------ ---------- Davison Chemicals 10.5% 10.7% 2.4% 23.6% Performance Chemicals .... 4.0% 2.1% 2.3% 8.4% Net sales...... 7.4% 6.5% 2.4% 16.3% - ------------------- --------- ---------- ------------ ---------- BY REGION: North America. 6.5% 8.8% 0.2% 15.5% Europe....... 3.7% 5.5% 5.2% 14.4% Asia Pacific. 8.0% 11.3% 1.9% 21.2% Latin America 34.9% (12.1)% 1.1% 23.9% ================================================================ Grace's sales in the three-month period ended March 31, 2005 were favorably impacted by higher unit volumes in refining technologies and construction chemicals products, with acquisitions contributing $16.4 million or 3.2 percentage points of the sales volume growth. Foreign currency translation contributed $12.2 million or 2.4 percentage points of the sales growth, mainly due to the strengthening of the Euro against the U.S. dollar compared with the prior year period. Selling price increases, implemented to partially offset a significant increase in raw material and energy costs, added approximately $9.4 million to 2005 first quarter sales. PRE-TAX INCOME FROM CORE OPERATIONS - Operating profit for the three months ended March 31, 2005 was higher as compared with the prior year period due to improved sales volume, particularly in refining technologies and construction-related products, and selling price increases implemented to partially offset higher raw material and energy costs. Corporate costs include corporate functional costs (such as financial and legal services, human resources, communications and information technology), the cost of corporate governance (including directors and officers ("D&O") liability insurance, a portion of which is allocated to noncore activities) and pension costs related to both corporate employees and to the effects of changes in assets and liabilities for all Grace pension plans. Corporate costs for the three months ended March 31, 2005 increased over the prior year period primarily due to higher pension expense that reflects updated assumptions for expected life-spans, the longevity of Grace's active work force, and amortization of deferred costs related to capital market returns in recent years. PRE-TAX LOSS FROM NONCORE ACTIVITIES - Pre-tax loss from noncore activities reflects items not directly related to Grace's core operating units. This category of costs and income is expected to be volatile as potentially material items are addressed through Grace's Chapter 11 proceedings and/or as the financial implications of Grace's legal contingencies become better understood. ================================================================ THREE MONTHS PRE-TAX LOSS FROM NONCORE ACTIVITIES ENDED (In millions) MARCH 31, ================================================================ 2005 2004 ---------- ---------- Asbestos administration and insurance recovery, net....................... $ (2.3) $ -- COLI income, net...................... 1.3 1.5 D&O insurance cost ................... (1.5) (1.3) Pension and postretirement benefit costs (1.3) (2.2) Translation effects - intercompany loan (14.9) -- Value of currency hedges.............. 14.5 -- Foreign currency transaction effects.. (0.2) (1.4) Montana criminal proceeding legal fees (6.0) -- Other................................. 2.3 (0.9) ---------- ---------- $ (8.1) $ (4.3) ================================================================ Pre-tax loss from noncore activities for the three-month period ended March 31, 2005 was comparable with the prior year period except for a pre-tax charge of $6.0 million in the first quarter of 2005 to accrue for legal fees related to the Montana criminal proceeding (see Note 12 to the Consolidated Financial Statements for more information). In March 2004, Grace began accounting for currency fluctuations on a (euro)293 million intercompany loan between Grace's subsidiaries in the United States and Germany as a component of operating results instead of as a component of other comprehensive income. The change was prompted by new tax laws in Germany and Grace's cash flow planning for its Chapter 11 reorganization, which indicated that it is no longer reasonable to consider this loan as part of the permanent capital structure in Germany. In May 2004, Grace entered into a series of foreign currency hedge agreements to mitigate future currency fluctuations on the remaining loan balance. These hedge agreements have varying rates that coincide with loan repayments due periodically through June 2005. For the three months ended March 31, 2005, a $14.5 million hedge gain was recognized, offset by a $14.9 million foreign currency loss, and was reported in other (income) expense. These hedges are considered derivative instruments that are viewed as risk management tools by Grace and are not used for trading or speculative purposes. CHAPTER 11 EXPENSES - Although it is difficult to measure precisely how Chapter 11 has impacted Grace's overall financial performance, there are certain added costs that are directly attributable to operating under the Bankruptcy Code. Net Chapter 11 expenses consist primarily of legal, financial and consulting fees incurred by Grace and three creditors' committees. Chapter 11 expenses for the three- I-27 month period ended March 31, 2005 are comparable to recent quarters and reflect normal and expected activity. Grace believes that Chapter 11 expenses will range between $2 million and $7 million per quarter for the foreseeable future. In addition, for the quarters ended March 31, 2005 and 2004, Grace's pre-tax income from core operations included expenses of $2.9 million and $3.7 million, respectively, for Chapter 11-related compensation charges. Poor stock price performance in the period leading up to and after the Filing diminished the value of Grace's stock option program to current and prospective employees, which caused Grace to change its long-term incentive compensation program into a cash-based program. There are numerous other indirect costs to manage Grace's Chapter 11 proceedings such as: management time devoted to Chapter 11 matters; added cost of debt capital; added costs of general business insurance, including D&O liability insurance premiums; and lost business and acquisition opportunities due to the complexities of operating under Chapter 11. INTEREST EXPENSE - Net interest expense in the three-month period ended March 31, 2005 was up $10.9 million compared with the prior year period. This increase is due to the interest to which general unsecured creditors would be entitled under the Plan. The Plan states that each holder of an allowed general unsecured claim shall be paid in full, plus post-petition interest. Post-petition interest shall accrue through the date of payment and shall be (i) for the holders of the Debtors' pre-petition bank credit facilities, at a rate of 6.09% per annum, compounded quarterly, (ii) for the holders of claims who, but for the Filing of the Chapter 11 Cases would be entitled under a contract or otherwise to accrue or be paid interest on such claim in a non-default (or non-overdue payment) situation under applicable non-bankruptcy law, the rate provided in the contract between a Debtor(s) and the claimant or such rate as may otherwise apply under applicable non-bankruptcy law, or (iii) for all other holders of allowed general unsecured claims, at a rate of 4.19% per annum, compounded annually. Under the Plan, such interest, which is payable 85% in cash and 15% in Grace common stock, will not be paid until the Plan is confirmed and funded. INCOME TAXES - Grace's provision for income taxes at the federal corporate rate of 35.0% was $4.1 million and $9.3 million for the three months ended March 31, 2005 and 2004, respectively. The primary differences between these amounts and the overall provision for income taxes is attributable to current period interest on tax contingencies and the non-deductibility of certain Chapter 11 expenses. BUSINESS SEGMENT OVERVIEW DAVISON CHEMICALS ================================================================ THREE MONTHS ENDED MARCH 31, ------------------------------------------ NET SALES BY $ Change % Change PRODUCT LINE Fav Fav (In millions) 2005 2004 (Unfav) (Unfav) - --------------------- --------- --------- ---------- ----------- Refining technologies..... $ 194.4 $ 145.1 $ 49.3 34.0% Specialty materials 140.3 125.8 14.5 11.5% --------- --------- ---------- ----------- TOTAL DAVISON CHEMICALS........ $ 334.7 $ 270.9 $ 63.8 23.6% ================================================================ ================================================================ THREE MONTHS ENDED MARCH 31, ------------------------------------------ $ Change % Change NET SALES BY REGION Fav Fav (In millions) 2005 2004 (Unfav) (Unfav) - --------------------- --------- --------- ---------- ----------- North America..... $ 130.0 $ 105.1 $ 24.9 23.7% Europe............ 137.4 117.5 19.9 16.9% Asia Pacific...... 50.3 37.7 12.6 33.4% Latin America..... 17.0 10.6 6.4 60.4% --------- --------- ---------- ----------- TOTAL DAVISON CHEMICALS........ $ 334.7 $ 270.9 $ 63.8 23.6% ================================================================ Sales The factors affecting demand were relatively strong in refining technologies and neutral in specialty materials in the first quarter of 2005 versus the prior year period. The increase in sales of refining technologies products resulted mainly from volume gains in response to high worldwide demand for catalysts that enhance refinery through-put, upgrade crude oil feedstocks and help produce cleaner fuels, and added revenue from the contractual pass-through of commodity metals costs. Sales of specialty materials products were about even with the prior period as higher volumes of polyolefin catalysts and favorable price/mix were offset by lower sales into consumer and automotive applications and lower sales in Western Europe. Sales from acquisitions accounted for $12.6 million, or 4.7 percentage points of the sales growth in the period, almost all of which was attributable to the acquisition of Alltech International Holdings, Inc. in August 2004. Sales increases also reflected favorable foreign currency translation, which contributed 2.4 percentage points of the sales increase in the period. Sales growth was strong in all regions. Sales in Asia Pacific and Latin America were up due to strong demand in all businesses from strong economic activity in China and increased sales activity in Latin America. In North America, increased sales were primarily attributable to volume growth, as well as favorable product price/mix, reflecting stronger economic activity in the United States. European sales were higher due to the effects of favorable I-28 currency translation and higher demand for refining technologies products. Operating Income Pre-tax operating income for the Davison Chemicals segment was up 17.8% compared with the first quarter of 2004, as contributions from higher sales of refining technologies products, acquisitions in specialty materials, favorable currency translation, favorable price/mix, and productivity gains more than offset a greater than 10% increase in raw materials and energy costs. Productivity gains were achieved primarily through increased output of manufacturing facilities and supply-chain initiatives. PERFORMANCE CHEMICALS ================================================================ THREE MONTHS ENDED MARCH 31, ---------------------------------------- NET SALES BY $ Change % Change PRODUCT LINE Fav Fav (In millions) 2005 2004 (Unfav) (Unfav) - ----------------------- -------- -------- ---------- ----------- Construction chemicals $ 129.8 $ 116.4 $ 13.4 11.5% Building materials.. 66.8 59.8 7.0 11.7% Sealants and coatings 71.9 71.4 0.5 0.7% -------- -------- ---------- ----------- TOTAL PERFORMANCE CHEMICALS.......... $ 268.5 $ 247.6 $ 20.9 8.4% ================================================================ ================================================================ THREE MONTHS ENDED MARCH 31, ---------------------------------------- $ Change % Change NET SALES BY REGION Fav Fav (In millions) 2005 2004 (Unfav) (Unfav) - ----------------------- -------- -------- ---------- ----------- North America....... $ 130.2 $ 120.1 $ 10.1 8.4% Europe.............. 83.8 75.9 7.9 10.4% Asia Pacific........ 37.8 35.0 2.8 8.0% Latin America....... 16.7 16.6 0.1 0.6% -------- -------- ---------- ----------- TOTAL PERFORMANCE CHEMICALS.......... $ 268.5 $ 247.6 $ 20.9 8.4% ================================================================ Sales The increase in sales for the Performance Chemicals segment in the first quarter of 2005 compared with the first quarter of 2004 was primarily attributable to volume growth in construction chemicals, favorable foreign currency translation, price increases in response to increasing raw material costs, and several recent acquisitions, primarily the acquisition of the Tri-Flex 30(R) synthetic roof underlayments product line. Acquisitions accounted for $3.8 million, or 1.5 percentage points of the sales growth, while currency translation accounted for 2.3 percentage points. The sales increase in construction chemicals primarily reflected the success of new product, key account and geographic growth programs, as well as strong U.S. construction activity. Favorable currency translation impacts (2.5 percentage points) and acquisitions (0.9 percentage points) also contributed to the increase. The increase in sales of building materials was driven by strong increases in waterproofing products, both structural and residential (roofing underlayments and flashing) products, reflecting strong U.S. construction activity and growth initiatives in residential channels. The Tri-Flex 30(R) synthetic underlayments acquisition in November 2004 (4.5 percentage points), price increases triggered by raw material cost increases, and favorable foreign currency translation (1.7 percentage points) also contributed to the increase. Sales increases in sealants and coatings reflected pricing actions in response to raw material cost increases and favorable foreign currency translation (2.5 percentage points), offset by volume declines versus a very strong first quarter 2004. Sales increases in North America reflected very strong U.S. construction activity, growth programs in construction chemicals and residential waterproofing, and the Tri-Flex 30(R) acquisition. In Europe, higher sales were primarily due to favorable foreign currency translation and new growth programs in construction chemicals. Sales in Asia Pacific increased as a result of broad-based volume growth and the effects of favorable foreign currency translation. Sales in Latin America were favorably impacted by currency translation and volume increases in construction chemicals and can sealants, offset by lower sales of closure sealants and coatings. Operating Income Pre-tax operating income was down 1.1% in the first quarter of 2005 compared with a record first quarter in 2004, reflecting significant increases in raw material and transportation costs, partially offset by sales increases, successful productivity programs and favorable foreign currency translation. OPERATING RETURNS ON ASSETS EMPLOYED - The following charts set forth the Davison Chemicals and Performance Chemicals total asset position and pre-tax return on average total assets as of March 31, 2005 and December 31, 2004. It should be noted that the manufacture of Davison Chemicals products generally requires significantly higher capital costs than the manufacture of Performance Chemical products. ================================================================ DAVISON CHEMICALS MARCH 31, December 31, (In millions) 2005 2004 - ---------------------------------- --------------- ------------- Trade receivables.............. $ 184.7 $ 172.0 Inventory...................... 155.3 151.8 Other current assets........... 18.0 4.9 --------------- ------------- Total current assets........... 358.0 328.7 Properties and equipment, net.. 419.2 437.6 Goodwill and other intangible assets....................... 102.4 105.7 Other assets................... 18.9 18.9 --------------- ------------- Total assets................... $ 898.5 $ 890.9 =============== ============= Pre-tax return on average total 17.9% 17.8% assets........................ ================================================================ Davison Chemicals' total assets increased by $7.6 million compared with the prior year. The increase was attributable to increased trade receivables and inventory due to increased sales, offset by $16.3 million of foreign I-29 currency translation due to the stronger U.S. dollar compared with December 31, 2004. ================================================================ PERFORMANCE CHEMICALS MARCH 31, December 31, (In millions) 2005 2004 ================================================================ Trade receivables............... $ 215.7 $ 219.1 Inventory....................... 103.0 96.5 Other current assets............ 12.9 14.5 ------------- ------------- Total current assets............ 331.6 330.1 Properties and equipment, net... 191.5 198.3 Goodwill and other intangible assets 99.1 102.2 Other assets.................... 44.9 43.9 ------------- ------------- Total assets.................... $ 667.1 $ 674.5 ============= ============= Pre-tax return on average total assets......................... 20.2% 20.7% ================================================================ Performance Chemicals' total assets decreased by $7.4 million compared with the prior year, of which $15.4 million was attributable to currency translation reflecting the stronger U.S. dollar compared with December 31, 2004. The offsetting increase was due to overall sales growth and inventory was higher to meet increased demand. The decline in properties and equipment was caused by first quarter net depreciation. VOLUNTARY BANKRUPTCY FILING As described under "Voluntary Bankruptcy Filing" in Notes 1 and 2 to the Consolidated Financial Statements, the Company and its principal U.S. operating subsidiary are debtors-in-possession under Chapter 11 of the Bankruptcy Code. Grace's non-U.S. subsidiaries, although not part of the Filing, are owned directly or indirectly by the Company's principal operating subsidiary or other filing entities. Consequently, it is likely that a Chapter 11 reorganization plan will involve the combined value of Grace's global businesses and its other assets to fund (with cash and/or securities) Grace's obligations as adjudicated through the bankruptcy process. Grace has analyzed its cash flow and capital needs to continue to fund its businesses and believes that, while in Chapter 11, sufficient cash flow and credit facilities are available to support its business strategy. Grace has a number of financial exposures originating from past businesses, products and events. These obligations arose from transactions and/or business practices that date back to when Grace was a much larger company, when it produced products or operated businesses that are no longer part of its revenue base, and when government regulations and scientific knowledge were much less advanced than today. The following table summarizes net noncore liabilities at March 31, 2005 and December 31, 2004: ================================================================ NET NONCORE LIABILITIES MARCH 31, December 31, (In millions) 2005 2004 ================================================================ Asbestos-related liabilities... $ (1,700.0) $ (1,700.0) Asbestos-related insurance receivable................... 500.0 500.0 ------------------------------ Asbestos-related liability, net (1,200.0) (1,200.0) Environmental remediation...... (343.8) (345.0) Postretirement benefits........ (115.3) (118.9) Retained obligations and other. (24.8) (25.1) Income taxes................... (208.7) (210.4) ------------------------------ NET NONCORE LIABILITY.......... $ (1,892.6) $ (1,899.4) ================================================================ The resolution of most of these noncore recorded and contingent liabilities will be determined through the Chapter 11 proceedings. Grace cannot predict with any certainty how, and for what amounts, any of these contingencies will be resolved. The amounts of these liabilities as ultimately determined through the Chapter 11 proceedings could be materially different from amounts recorded by Grace at March 31, 2005. PLAN OF REORGANIZATION - On November 13, 2004 Grace filed a plan of reorganization, as well as several associated documents, including a disclosure statement, with the Bankruptcy Court. On January 13, 2005, Grace filed an amended plan of reorganization (the "Plan") and related documents to address certain objections of creditors and other interested parties. The amended Plan is supported by committees representing general unsecured creditors and equity holders, but is not supported by committees representing asbestos personal injury claimants and asbestos property damage claimants. See Note 2 to the Consolidated Financial Statements for more information on Grace's plan of reorganization. RISKS OF THE PLAN - Grace intends to address all pending and future asbestos-related claims and all other pre-petition claims as outlined in the Plan. However, Grace may not be successful in obtaining approval of the Plan by the Bankruptcy Court. Instead, a materially different plan of reorganization may ultimately be approved and, under the ultimate plan of reorganization, the interests of the Company's shareholders could be substantially diluted or cancelled. The value of Grace common stock following a plan of reorganization, and the extent of any recovery by non-asbestos-related creditors, will depend principally on the allowed value of Grace's asbestos-related claims as determined by the Bankruptcy Court. Grace's proposed plan of reorganization assumes several fundamental conditions including: 1. Grace's asbestos-related liabilities can be resolved at a net present value cost of no more than $1,700 million (including $87 million for pre-petition asbestos-related contractual settlements and I-30 judgments), including all property damage claims (including ZAI) and all pending and future personal injury claims; and 2. Assets from litigation settlement agreements with Sealed Air and Fresenius will be available to fund the liability under the Plan. There can be no guarantee that these two fundamental conditions can be met. The measure of Grace's asbestos-related liabilities could be settled by the Bankruptcy Court (in conformity with Grace's Plan or otherwise), by a negotiation with interested parties, and/or by legislation (currently being considered by the U.S. Congress) for the personal injury component of this contingency. Any resolution, other than that reflected in the Plan, could have a material adverse effect on the percentage of Grace common stock to be retained by current shareholders of Grace beyond that reflected in the proforma financial information presented below. Also, a resolution of personal injury claims based on federal legislation that would provide for payments to be made by companies and their insurers to a government-administered trust may not satisfy the conditions precedent under the litigation settlement agreements with Sealed Air and Fresenius and, therefore, may reduce or eliminate the availability of these assets to fund a plan of reorganization. Grace will adjust its financial statements and the proforma effects of its Plan as facts and circumstances warrant. PROFORMA FINANCIAL INFORMATION - The proforma financial information of Grace presented below reflects the accounting effects of the Plan (1) as if it were put in effect on the date of Grace's most recent consolidated balance sheet - March 31, 2005, and (2) as if it were in effect for (a) the full year ended December 31, 2004, and (b) the three months ended March 31, 2005. The proforma financial information included herein, may not be consistent with the Plan documents filed on January 13, 2005 due to subsequent changes in operations and accounting estimates. Such proforma financial statements show how Grace's assets, liabilities, equity and income would be affected by the Plan as follows: A. Borrowings Under New Debt Agreements and Contingencies The Plan reflects the assumed establishment of a new $1,000 million debt facility to fund settled claims payable at the effective date of the Plan (approximately $800 million) and to provide working capital (approximately $200 million) for continuing operations. Proforma expenses reflect an assumed 7% interest rate on outstanding borrowings. No such facility currently exists but, in Grace's view based on discussions with prospective lenders, one can be established before the effective date of the Plan. In addition, the proforma financial information reflects $150.0 million in contingencies to pay professional and bank fees, other non-operating liabilities and their related tax effects that will not become liabilities until the effective date of the Plan. B. Fresenius and Sealed Air Settlements The Plan reflects the value, in the form of cash and securities, expected to be realized under each litigation settlement agreement as follows: $115.0 million of cash from Fresenius Medical Care; and, $1,046.5 million of estimated value from Sealed Air Corporation (calculated as of March 31, 2005) in the form of $512.5 million of cash plus accrued interest at 5.5% from December 21, 2002 compounded annually (approximately $66.4 million), and nine million shares of Sealed Air common stock valued at $51.94 per share (approximately $467.5 million). Tax accounts have been adjusted to reflect the satisfaction of Grace's recorded liabilities by way of these third-party agreements. The Fresenius settlement amount will be payable to Grace and will be accounted for as income. The Sealed Air settlement assets will be paid directly to the asbestos trust by Sealed Air and will be accounted for as satisfaction of a portion of Grace's recorded asbestos-related liability. In addition, the valuation allowance related to Grace's federal deferred tax assets will not be required as a result of taxable amounts from these settlements and has therefore been reversed. The Sealed Air settlement remains subject to Bankruptcy Court approval, and both the Sealed Air and Fresenius settlements are subject to the fulfillment of specified conditions. C. Payment of Pre-Petition Liabilities The Plan reflects the transfer of funds and securities to settle estimated obligations payable under the Plan at the effective date. Tax accounts are adjusted to reflect the change in nature of Grace's tax assets from predominately temporary differences to predominately time-limited tax net operating losses. Non-asbestos pass-through liabilities are assumed to be paid in cash when due. The payment of liability for tax claims and contingencies includes an approximate $90 million payment made in April 2005 to the IRS related to liability and accrued interest for the 1993-1996 tax periods (see Note 12 to the Consolidated Financial Statements). D. Proforma Consolidated Statement of Operations and Capital Structure The proforma income adjustments reflect the elimination from Grace's March 31, 2005 Consolidated Statements of Operations of: (1) charges and expenses directly related to Chapter 11, (2) the accounting for estimates and provisions directly related to the Plan, and (3) the I-31 addition of interest and new common shares related to the assumed financing of the Plan. For purposes of proforma earnings per share and proforma share capital, the trading value of Grace's common stock at March 31, 2005, of $8.52 per share, was used for calculating issued and outstanding shares. At this per share valuation, it is assumed that 69.3 million shares will be issued at the effective date of the Plan to fund asbestos and general unsecured claims, 15.3 million shares would be issuable upon exercise of warrants to satisfy Grace's estimate of PI-AO claims, and 1.2 million shares would be issued upon exercise of in-the-money stock options. Such trading value is presented solely for purposes of presenting a proforma Consolidated Statement of Operations and may not be indicative of the actual trading value of Grace common stock following the effective date of the Plan. Should Grace's distributable value per share at the effective date of the Plan be below approximately $8.75 per share, Grace would be required to revalue its balance sheet for a change in control. These proforma financial statements reflect no change in assets or income related to this potential accounting outcome. E. Non-asbestos Contingencies The accompanying proforma financial information assumes all non-asbestos related contingencies (including environmental, tax and civil and criminal litigation) are settled for recorded amounts as of March 31, 2005. Certain liabilities are assumed to be paid at the effective date based on Grace's estimate of amounts that will be determinable and payable. The remainder, which would also be subject to the approved plan of reorganization, is assumed to be paid subsequent to the effective date as amounts are either not due until a later date or will be determined through post-effective-date litigation. The ultimate value of such claims may change materially as Grace's Chapter 11 and other legal proceedings further define Grace's non-asbestos related obligations. I-32 ==================================================================================================================================== PROFORMA ADJUSTMENTS --------------------------------------------------- BORROWINGS PAYMENT OF W. R. GRACE & CO AND SUBSIDIARIES MARCH 31, UNDER NEW DEBT SEALED AIR/ REMAINING MARCH 31, PROFORMA CONDENSED CONSOLIDATED BALANCE SHEET 2005 AGREEMENTS FRESENIUS PRE-PETITION 2005 (In millions) AS REPORTED AND CONTINGENCIES SETTLEMENTS LIABILITIES PROFORMA ==================================================================================================================================== ASSETS CURRENT ASSETS Cash and cash equivalents........................ $ 474.8 $ 800.0 $ 115.0 $ (1,109.4) $ 280.4 Other current assets............................. 732.0 -- -- -- 732.0 ---------------- ----------------- ----------------- --------------- ------------- TOTAL CURRENT ASSETS.......................... 1,206.8 800.0 115.0 (1,109.4) 1,012.4 Non-current operating assets..................... 1,011.2 -- -- -- 1,011.2 Cash value of life insurance..................... 81.0 -- -- -- 81.0 Deferred income taxes: Net operating loss carryforwards.............. 69.3 -- (40.3) 124.2 153.2 Temporary differences, net of valuation allowance .................................... 595.3 26.3 (366.3) (124.2) 131.1 Asbestos-related insurance....................... 500.0 -- -- -- 500.0 ---------------- ----------------- ----------------- --------------- ------------- TOTAL ASSETS.................................. $ 3,463.6 $ 826.3 $ (291.6) $ (1,109.4) $ 2,888.9 ================ ================= ================= =============== ============= LIABILITIES AND SHAREHOLDERS' EQUITY (DEFICIT) Total Current Liabilities........................ $ 330.6 $ -- $ -- $ -- $ 330.6 Long-term debt................................... 1.1 800.0 -- -- 801.1 Other noncurrent liabilities..................... 560.5 -- -- -- 560.5 ---------------- ----------------- ----------------- --------------- ------------- TOTAL LIABILITIES NOT SUBJECT TO COMPROMISE...... 892.2 800.0 -- -- 1,692.2 Bank debt/letters of credit/capital leases....... 655.1 -- -- (652.9) 2.2 Liability for asbestos-related litigation and claims ......................................... 1,700.0 -- (1,046.5) (523.5) 130.0 Liability for environmental remediation.......... 343.8 -- -- (231.3) 112.5 Liability for postretirement health and special pensions........................................ 194.3 -- -- (9.2) 185.1 Liability for accounts payable and litigation.... 98.2 -- -- (74.1) 24.1 Liability for tax claims and contingencies....... 208.7 -- -- (159.0) 49.7 Other nonoperating liabilities, including Plan contingencies................................... -- 150.0 -- (50.0) 100.0 ---------------- ----------------- ----------------- --------------- ------------- LIABILITIES SUBJECT TO COMPROMISE................ 3,200.1 150.0 (1,046.5) (1,700.0) 603.6 ---------------- ----------------- ----------------- --------------- ------------- TOTAL LIABILITIES................................ 4,092.3 950.0 (1,046.5) (1,700.0) 2,295.8 ---------------- ----------------- ----------------- --------------- ------------- SHAREHOLDER'S EQUITY (DEFICIT) Share capital.................................... 424.3 -- -- 590.6 1,014.9 Retained earnings and other equity items......... (1,053.0) (123.7) 754.9 -- (421.8) ---------------- ----------------- ----------------- --------------- ------------- TOTAL SHAREHOLDERS' EQUITY (DEFICIT) ............ (628.7) (123.7) 754.9 590.6 593.1 ---------------- ----------------- ----------------- --------------- ------------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 3,463.6 $ 826.3 $ (291.6) $ (1,109.4) $ 2,888.9 (Deficit) ...................................... ==================================================================================================================================== ==================================================================================================================================== YEAR ENDED DECEMBER 31, 2004 THREE MONTH PERIOD ENDED MARCH 31, 2005 ---------------------------- --------------------------------------- W.R. GRACE & CO. AND SUBSIDIARIES PROFORMA CONSOLIDATED STATEMENTS OF OPERATIONS AS PROFORMA AS PROFORMA (In millions, except per share amounts) REPORTED ADJUSTMENTS PROFORMA REPORTED ADJUSTMENTS PROFORMA ==================================================================================================================================== NET SALES........................................ $ 2,259.9 $ -- $ 2,259.9 $ 603.2 $ -- $ 603.2 ------------ --------------- ------------ ----------- -------------- ----------- Cost of goods sold, exclusive of depreciation and amortization shown separately below....... 1,431.5 -- 1,431.5 392.7 -- 392.7 Selling, general and administrative expenses, exclusive of net pension expense shown separately below.............................. 442.8 -- 442.8 119.3 (9.9) 109.4 Depreciation and amortization.................... 108.8 -- 108.8 28.8 -- 28.8 Research and development expenses................ 51.1 -- 51.1 15.1 -- 15.1 Net pension expense.............................. 61.9 -- 61.9 17.6 -- 17.6 Interest expense and related financing costs..... 111.1 (51.8) 59.3 14.6 (0.4) 14.2 Provision for environmental remediation.......... 21.6 (21.6) -- -- -- -- Provision for asbestos-related litigation........ 476.6 (476.6) -- -- -- -- Other (income) expense .......................... (68.4) 62.3 (6.1) (6.1) -- (6.1) ------------ --------------- ------------ ----------- -------------- ----------- TOTAL COSTS AND EXPENSES......................... 2,637.0 (487.7) 2,149.3 582.0 (10.3) 571.7 INCOME (LOSS) BEFORE CHAPTER 11 EXPENSES, INCOME TAXES AND MINORITY INTEREST................... (377.1) 487.7 110.6 21.2 10.3 31.5 Chapter 11 expenses, net......................... (18.0) 18.0 -- (6.0) 6.0 -- Benefit from (provision for) income taxes........ 1.5 (37.2) (35.7) (8.6) (1.2) (9.8) Minority interest in consolidated entities....... (8.7) -- (8.7) (3.5) -- (3.5) ------------ --------------- ------------ ----------- -------------- ----------- NET INCOME (LOSS)................................ $ (402.3) $ 468.5 $ 66.2 $ 3.1 $ 15.1 $ 18.2 ============ =============== ============ =========== ============== =========== BASIC EARNINGS (LOSS) PER COMMON SHARE........... $ (6.11) $ 0.49 $ 0.05 $ 0.13 Weighted average number of basic shares.......... 65.8 70.5 136.3 66.6 70.5 137.1 DILUTED EARNINGS (LOSS) PER COMMON SHARE......... $ (6.11) $ 0.44 $ 0.05 $ 0.12 Weighted average number of diluted shares........ 65.8 85.8 151.6 67.3 85.8 153.1 ==================================================================================================================================== I-33 FINANCIAL CONDITION ASBESTOS-RELATED LITIGATION - See Note 3 to the Consolidated Financial Statements. ENVIRONMENTAL MATTERS - See Note 12 to the Consolidated Financial Statements. DEFINED BENEFIT PENSION PLANS - Grace sponsors defined benefit pension plans for its employees in the United States, Canada, the United Kingdom, Australia, Germany, Italy, France, Spain, Denmark, Japan, Philippines, South Korea, Taiwan, South Africa, Brazil and Mexico and funds government sponsored programs in other countries where it operates. Certain of the Grace sponsored plans are advance-funded and others are pay-as-you-go. The advance-funded plans are administered by trustees who direct the management of plan assets and arrange to have obligations paid when due out of a trust. The most significant advance-funded plans cover Grace's salaried employees in the U.S. and U.K. and employees covered by collective bargaining agreements at certain of its U.S. facilities. At the December 31, 2004 measurement date for the U.S. advance-funded defined benefit pension plans (the "Plans"), the accumulated benefit obligation ("ABO") was approximately $958 million as measured under U.S. generally accepted accounting principles. The ABO is measured as the present value (using a 5.5% discount rate as of December 31, 2004) of vested and non-vested benefits earned from employee service to date, based upon current salary levels. Such discount rate is based on a high quality bond portfolio designed to meet the payout pattern of the Plans. Of the participants in the Plans, approximately 80% are current retirees or employees of former Grace businesses, making the payout pattern skewed to the nearer term. Assets available to fund the ABO at December 31, 2004 were approximately $666 million, or approximately $292 million less than the measured obligation. Assets available at March 31, 2005 totaled approximately $643 million down $23 million from December 31, 2004 primarily due to negative equity market returns. It is Grace's intention to satisfy its obligations under the Plans and to comply with all of the requirements of the Employee Retirement Income Security Act of 1974. In that regard, Grace will seek Bankruptcy Court approval to fund minimum required payments of approximately $60 million for the July 2005 to July 2006 period. However, there can be no assurance that the Bankruptcy Court will continue to approve arrangements to satisfy the funding needs of the Plans. Contributions to non-U.S. plans are not subject to Bankruptcy Court approval and Grace intends to fund such plans based on actuarial and trustee recommendations. See Note 13 to the Consolidated Financial Statements for the components of net periodic benefit cost for each of the three-month periods ended March 31, 2005 and 2004. Grace expects total pension expense for 2005 to be approximately $68 million, and benefit payments to retirees to aggregate to approximately $92 million for all pension programs in 2005. At March 31, 2005, Grace's recorded pension liability for U.S. and non-U.S. underfunded plans was $510.1 million ($431.1 million included in liabilities not subject to compromise and $79.0 million related to supplemental pension benefits, included in "liabilities subject to compromise") which includes the following components: (1) shortfall between dedicated assets and ABO of underfunded plans ($304.1 million); and (2) ABO of pay-as-you-go plans ($206.0 million). POSTRETIREMENT BENEFITS OTHER THAN PENSIONS - Grace provides certain health care and life insurance benefits for retired employees, a large majority of which pertain to retirees of previously divested businesses. These plans are unfunded, and Grace pays the costs of benefits under these plans as they are incurred. Grace's share of benefits under this program was $2.3 million during the three months ended March 31, 2005, compared with $2.6 million in the prior-year period. Grace's recorded liability for postretirement benefits of $115.3 million at March 31, 2005 is stated at net present value discounted at 5.5% (as discussed under Defined Benefit Pension Plans). Grace's Plan provides for the continuation of these benefits. In December 2003, President Bush signed the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the "Act") into law. The Act introduces a prescription drug benefit under Medicare ("Medicare Part D") as well as a federal subsidy to companies that provide a benefit that is at least actuarially equivalent (as defined in the Act) to Medicare Part D. On January 21, 2005, the Center for Medicare and Medicaid Services released the final regulations implementing the Act. Grace has determined that the prescription drug benefit under its postretirement health care plan is actuarially equivalent to the Medicare Part D benefit. Therefore, the accumulated postretirement benefit obligation (APBO) was remeasured as of January 21, 2005 to reflect the amount associated with the federal subsidy. The APBO was reduced by approximately $22.0 million and the net periodic benefit cost for 2005 will be reduced by approximately $2.8 million ($0.7 million for the three-month period ended March 31, 2005) due to the effect of the federal subsidy. I-34 LIQUIDITY AND CAPITAL RESOURCES CASH RESOURCES AND AVAILABLE CREDIT FACILITIES - At March 31, 2005, Grace had $555.8 million in cash and cash-like assets on hand ($474.8 million in cash and cash equivalents and $81.0 million in net cash value of life insurance). In addition, Grace had access to committed credit facilities aggregating $250.0 million under the DIP facility, of which $197.1 million (letters of credit and holdback provisions) was available at March 31, 2005. The term of the DIP facility expires April 1, 2006. Grace believes that these funds and credit facilities will be sufficient to finance its business strategy while in Chapter 11. CASH FLOW FROM CORE OPERATIONS - Grace's net cash flow from core operations before investing for the three-month period ended March 31, 2005 decreased from the prior-year period due to increased investment in working capital and an increase in capital expenditures. =============================================================== THREE MONTHS ENDED MARCH 31, CORE OPERATIONS ------------------------ (In millions) 2005 2004 =============================================================== CASH FLOWS: Pre-tax operating income............ $ 39.7 $ 38.5 Depreciation and amortization....... 28.8 27.2 ------------------------ PRE-TAX EARNINGS BEFORE DEPRECIATION AND AMORTIZATION................. 68.5 65.7 Working capital and other changes... (74.1) (26.4) ------------------------ CASH FLOW BEFORE INVESTING.......... (5.6) 39.3 Capital expenditures................ (12.4) (9.1) Businesses acquired................. (2.2) -- ------------------------ NET CASH FLOW FROM CORE OPERATIONS.. $ (20.2) $ 30.2 =============================================================== The increased investment in working capital was primarily due to payments of approximately $70 million for prior year performance incentives and customer volume rebates. Grace expects to continue to invest excess cash flow and/or other available capital resources in its core business base. These investments are likely to be in the form of added plant capacity, product line extensions and geographic market expansions, and/or acquisitions in existing product lines. Investments that are outside the ordinary course of business may be subject to Bankruptcy Court approval and review by the Chapter 11 committees. CASH FLOW FROM NONCORE ACTIVITIES - The cash flow from Grace's noncore activities can be volatile. Expenditures are generally governed by Bankruptcy Court rulings and receipts are generally nonrecurring. Much of the noncore spending in the past three years has been under Chapter 11 first-day motions that allow Grace to fund postretirement benefits and required environmental remediation on Grace-owned sites. Cash inflows have been from asbestos-related insurance recovery on pre-Chapter 11 liability payments, and unusual events. In April 2005, Grace made a $90 million payment to the U.S. Internal Revenue Service to fund taxes and interest on settled amounts as approved by the Bankruptcy Court. =============================================================== THREE MONTHS ENDED MARCH 31, NONCORE ACTIVITIES ------------------------ (In millions) 2005 2004 =============================================================== CASH FLOWS: Pre-tax loss from noncore activities $ (8.1) $ (4.3) Non-cash charges..................... (2.9) 3.5 Cash spending for: Asbestos-related litigation, net of insurance recovery......... (2.1) (0.3) Environmental remediation.......... (1.2) (2.9) Postretirement benefits............ (2.3) (2.6) Retained obligations and other..... (0.3) (0.4) ------------------------ NET CASH OUTFLOW FOR NONCORE ACTIVITIES ........................ $(16.9) $ (7.0) =============================================================== See the Consolidated Statements of Cash Flows included in the Consolidated Financial Statements for investing and financing activities for each of the three-month periods ended March 31, 2005 and 2004. DEBT AND OTHER CONTRACTUAL OBLIGATIONS - Total debt outstanding at March 31, 2005 was $666.3 million, including $140.4 million of accrued interest on pre-petition debt. As a result of the Filing, Grace is now in default on $514.7 million of pre-petition debt which, together with accrued interest thereon, has been included in "liabilities subject to compromise" as of March 31, 2005. The automatic stay provided under the Bankruptcy Code prevents Grace's lenders from taking any action to collect the principal amounts as well as related accrued interest. However, Grace will continue to accrue and report interest on such debt during the Chapter 11 proceedings unless further developments lead management to conclude that it is probable that such interest will be compromised. See Note 12 to the Consolidated Financial Statements for a discussion of financial assurances. FORWARD-LOOKING STATEMENTS - The forward-looking statements contained in this document are based on current expectations regarding important risk factors. Actual results may differ materially from those expressed. In addition to the uncertainties referred to in Management's Discussion and Analysis of Financial Condition and Results of Operations, other uncertainties include: the impact of worldwide economic conditions; pricing of both Grace's products and raw materials; customer outages and customer demand; factors I-35 resulting from fluctuations in interest rates and foreign currencies; the impact of competitive products and pricing; the continued success of Grace's process improvement initiatives; the impact of tax, legislation and other regulations in the jurisdictions in which Grace operates; and developments in and the outcome of the Chapter 11 proceedings discussed above. Also, see "Introduction and Overview - Projections and Other Forward-Looking Information" in Item 1 of Grace's current Annual Report on Form 10-K. I-36 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Grace had no outstanding derivative financial instruments that qualify for accounting treatment under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" at March 31, 2005. Grace has entered into foreign exchange forward contracts to manage exposure to fluctuations in foreign currency exchange rates on an intercompany loan between Grace and a subsidiary in Germany. (See Note 5 to the Consolidated Financial Statements.) For further information concerning Grace's quantitative and qualitative disclosures about market risk, refer to Note 8 in the Consolidated Financial Statements in Grace's 2004 Annual Report on Form 10-K. ITEM 4. CONTROLS AND PROCEDURES GENERAL STATEMENT OF RESPONSIBILITY The management of Grace is responsible for the preparation, integrity and objectivity of the Consolidated Financial Statements and the other information included in this report. Such financial information has been prepared in conformity with accounting principles generally accepted in the United States of America and accordingly includes certain amounts that represent management's best estimates and judgments. Actual amounts could differ from those estimates. Management is also responsible for establishing and maintaining adequate internal control over financial reporting. These internal controls consist of policies and procedures that are designed to assess and monitor the effectiveness of the control environment including: risk identification, governance structure, delegations of authority, information flow, communications and control activities. A chartered Disclosure Committee oversees Grace's public financial reporting process and key managers are required to confirm their compliance with Grace's policies and internal controls quarterly. While no system of internal controls can ensure elimination of all errors and irregularities, Grace's internal controls, which are reviewed and modified in response to changing conditions, have been designed to provide reasonable assurance that assets are safeguarded, policies and procedures are followed, transactions are properly executed and reported, and appropriate disclosures are made. The concept of reasonable assurance is based on the recognition that there are limitations in all systems of internal control and that the costs of such systems should be balanced with their benefits. The Audit Committee of the Board of Directors, which is comprised solely of independent directors, meets regularly with Grace's senior financial management, internal auditors and independent auditors to review audit plans and results, as well as the actions taken by management in discharging its responsibilities for accounting, financial reporting and internal controls. The Audit Committee is responsible for the selection and compensation of the independent auditors. Grace's financial management, internal auditors and independent auditors have direct and confidential access to the Audit Committee at all times. EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES As of March 31, 2005, Grace carried out an evaluation of the effectiveness of the design and operation of its disclosure controls and procedures pursuant to Rule 13a-15 under the Securities Exchange Act of 1934, as amended (the "Exchange Act"). Based upon that evaluation, Grace's Chief Executive Officer and Chief Financial Officer concluded that Grace's disclosure controls and procedures are effective in ensuring that information required to be disclosed in Grace's periodic filings under the Exchange Act is accumulated and communicated to such officers to allow timely decisions regarding required disclosures. There was no significant change in Grace's internal control over financial reporting during the quarter ended March 31, 2005 that has materially affected, or is reasonably likely to materially affect, Grace's internal control over financial reporting. I-37 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS - -------------------------------------------------------------------------------- Notes 2, 3 and 12 to the interim consolidated financial statements in Part I of this Report are incorporated herein by reference. ITEM 6. EXHIBITS - -------------------------------------------------------------------------------- Exhibits. The following is a list of Exhibits filed as part of this Quarterly Report on Form 10-Q: 15 Accountants' Awareness Letter 31.1 Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002 32 Certification of Periodic Report by Chief Executive Officer and Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 II-1 SIGNATURE In accordance with the requirements of the Securities Exchange Act of 1934, the Registrant caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. W.R. GRACE & CO --------------- (Registrant) Date: May 6, 2005 By /s/ Paul J. Norris ------------------ Paul J. Norris Chairman and Chief Executive Officer Date: May 6, 2005 By /s/ Robert M. Tarola -------------------- Robert M. Tarola Senior Vice President and Chief Financial Officer (Principal Accounting Officer) II-2 EXHIBIT INDEX EXHIBIT NO. DESCRIPTION OF EXHIBIT - ----------- ---------------------- 15 Accountants' Awareness Letter 31.1 Certification of Periodic Report by Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002 31.2 Certification of Periodic Report by Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002 32 Certification of Periodic Report by Chief Executive Officer and Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002 II-3
W.R. Grace & Co. (GRA)
Filed: 6 May 05, 12:00am